FCA’s Mission

The Farm Credit Administration will promote a safe and sound, competitive Farm

Credit System to finance rural America as

authorized by Congress.

FARM CREDIT ADMINISTRATION

Mid-Year Report

1998
FCA 1998

Mid-Year Report

Contents

Preface ................................................................................................................................................................................... 1

Executive Summary

John Moore ..................................................................................................................................................................................................... 2

Financial Performance of the

Farm Credit System for the First Half of 1998 ................................................................................................................... 5

Laurie Hopkins and Andrew Jacob

Federal Income Tax Options

Available to FCSIs and Their Competitors ........................................................................................................................ 19

Linda Sherman and Robert Andros

Risks Associated with the Millennial Date Change .......................................................................................................... 29

Thomas Glenn and Robert Andros

Effects of a Prolonged Economic Depression in Southeast Asia on the U.S. Farm Economy ........................................ 37

Paul Prentice – Farm Sector Economics, Inc.

Farm Credit Administration

Fiscal Year 1999 Regulatory Performance Plan ................................................................................................................. 48

Farm Credit Administration’s Loan Portfolio Management Symposium........................................................................ 50

Corporate Restructuring of Farm Credit System Institutions ......................................................................................... 52

Elna Luopa

Major Financial Indicators by System, Quarterly Comparison ....................................................................................... 58

Major Financial Indicators by District .............................................................................................................................. 59

Glossary ............................................................................................................................................................................... 60

Report Manager

John C. Moore, Jr.

Chief Economist
FCA 1998

Mid-Year Report

Preface

those of Agency analysts and do not necessarily reflect the opinions of the FCA Board

or FCA management.

System institutions are required to make

certain disclosures to stockholders, investors,

and the general public. The Federal Farm

Credit Banks Funding Corporation, for

example, makes such disclosures to investors

in System-wide securities on behalf of the

issuing banks. Other individual System institutions provide similar disclosures in reports to their respective stockholders. The

quarterly Summary Report of Condition and

Performance of the Farm Credit System, published by the Funding Corporation, offers a

detailed set of tables showing the financial

results of the Farm Credit banks combined

with their affiliated organizations.

The Farm Credit Administration (FCA) publishes a report on the condition and performance of the Farm Credit System (FCS or

System) twice each year, first in the Mid-Year

Report that covers the first six months and

then in the Report on the Financial Condition and Performance of the Farm Credit

System, which covers the calendar year.

These reports focus on identifying risks from

both within the System and outside it. In

addition, the Mid-Year Report provides special articles on risk and other policy-related

issues affecting System institutions. These

reports also contain updates on the System’s

corporate restructuring activities, FCA’s

Regulatory Performance Plan, special programs and conferences, as well as tables summarizing the latest indicators of the System’s

financial performance. Each quarter FCA

also posts System financial indicator tables

as well as updates on the System’s corporate

restructuring efforts on its Internet Website

(see address below).

This 1998 Mid-Year Report on the Farm

Credit System draws from a variety of sources

including quarterly Farm Credit Administration (FCA or Agency) Call Reports, quarterly System reports, U.S. Department of

Agriculture (USDA) reports, and other Federal, state, and commercial information

sources. The figures and tables detailing the

System’s financial performance reflect information from reports filed with the Agency

by System institutions as of the close of business September 1, 1998. Unless indicated

otherwise, all projections and analyses are

Questions regarding the content of this report

may be directed to C. Edward Harshbarger,

Director, Risk Analysis Division, Office of Policy

and Analysis or to John C. Moore, Jr., Chief

Economist, 703-883-4455

Single-copy subscriptions are available to the

public free of charge. This report and recent

past reports are also available on FCA’s Website

(http://www.fca.gov). Requests for subscriptions or address changes should be mailed to:

Office of Congressional and Public Affairs, Farm

Credit Administration, 1501 Farm Credit

Drive, McLean, VA 22101-5090; E-mail:

info-line@fca.gov.

1
FCA 1998

Mid-Year Report

Executive Summary

to farmers) four quarters in a row. Loans to

cooperatives, meanwhile, fell slightly over the

last 12-month period and loans made in

connection with international transactions

continued a trend of paydowns of loans to

some countries.

The report contains a special section linking

conditions in the agricultural economy to

commodity concentrations (as of June 30,

1998) in the Farm Credit System’s loan portfolios. The largest such concentrations in

System-wide farm lending portfolios are corn

(10.3 percent), dairy (10.2 percent), beef

cattle (8.3 percent), wheat (4.5 percent), hogs

(4.3 percent), cotton (3.4 percent), and soybeans (2.7 percent). Except for dairy and

cotton, these commodities are experiencing

serious price declines. As one would expect,

a more detailed, district-by-district review

turned up much higher concentrations of

these stressed commodities in certain districts.

However, the credit quality of the System’s

portfolios continued to improve or remain

stable as acceptable loans reached 89.2 percent of loan volume. Other loan-quality

indicators also showed consistent upward

trends: nonperforming assets declined to 1.3

percent of total loans; non-accrual loans fell

to one percent of total loans, and delinquencies remained stable and low. The effects of

the recent deterioration in economic conditions would not be expected to show up in

credit quality indicators until later.

System capital increased by $1.1 billion to

$12.2 billion or 15.1 percent of assets, up

from 14.5 percent a year earlier. Surplus, the

type of capital that counts toward two relatively new standards, reached $8.8 billion,

while “restricted capital” (the amount in the

Farm Credit System Insurance Fund) increased to $1.4 billion.

The System’s net income for the first six

months of 1998 was $666 million. The $59

million gain from the year before resulted

Conditions in the agricultural economy for

a wide range of commodities declined significantly during the first half of 1998. In

fact, prices for wheat and corn have fallen so

low that several billion dollars in unanticipated loan deficiency payments will be made

to farmers in the second half of 1998. The

Farm Credit System’s (FCS’s) solid financial

results for the first half of the year do not yet

reflect the stress of these deteriorating financial conditions. Rather, the June 30, 1998,

results show that FCS institutions have been

able to maintain strong loan volume growth,

a high quality loan portfolio, and strong earnings, and they have continued to improve

risk-bearing capacity in the form of higher

capital levels. The System’s financial statements will likely begin to show the effects of

the downturn in conditions by the end of

1998 or early 1999, but at the moment, its

institutions are in an excellent financial

position to withstand the emerging risks.

The System’s loan volume continued to grow

briskly, with gross outstanding loans at $65.6

billion on June 30, 1998—an increase of 4.8

percent from the previous year. The largest

increases came in short- and intermediateterm loans, which jumped 11.6 percent, while

real estate loans increased by 4.6 percent.

This growth resulted from continued strong

gains in land prices, a trend that may soon

reverse if, as expected, farm income declines

substantially from 1996 and 1997 levels. The

upsurge in short- and intermediate-term

loans may be partly attributable to farmers’

choosing to store crops and wait for higher

prices while borrowing more for current

operating expenses. Other factors influencing loan growth include the System’s enhanced marketing efforts, more efficient

credit-delivery systems, and competitive pricing programs. As of the end of the first

quarter of 1998, however, the increase in

agricultural loans at commercial banks was

greater than that in the System. In fact, as of

the end of the first quarter commercial banks’

annual growth rates for agricultural loans

have outpaced the System’s growth (in loans

2
FCA 1998

Mid-Year Report

from the increased loan volume and higher

capital levels. In addition, while various economic and financial developments have increased spreads between System securities

and those of the U.S. Treasury, funding costs

have remained stable. The System’s annualized return on average assets thus increased

slightly, to 1.68 percent.

This Mid-Year Report also offers several other

pertinent analyses. One article looks at the

various tax structures available to System

institutions and their commercial bank counterparts and compares the tax savings available to each. For example, although cooperatives have the same rights and responsibilities as other businesses, including the

responsibility to pay taxes, their unique structure and purpose requires a separate section

in the Internal Revenue (IR) Code, Subchapter T, which sets forth the qualifications and

criteria for the taxation of cooperatives,

including several options for the distribution

of surplus or earnings. The IR Code provides the option for taxation on the earnings

of cooperatives, at either the corporate or the

individual level—whichever is most advantageous to the cooperative and its members.

This requirement differs from those for most

investor-owned general businesses, which

pay taxes at both the corporate level and

again when dividends are distributed at the

individual level. Half of the System’s taxable

institutions now file as Subchapter T

cooperatives.

Recent legislation gives many commercial

banks and thrifts the opportunity to reorganize as Subchapter S corporations, which

enjoy tax benefits similar to those accorded

Subchapter T cooperatives. Since there are

substantial financial benefits associated with

single taxation, more than 10 percent of the

nation’s banks, many located in rural and

agricultural sections of the country, have converted to S corporations in the last 18

months. Many more are expected to convert

in the near future.

An article on the year 2000 (Y2K) computer

problem discusses the serious challenge facing the financial services sector, including

Farm Credit System institutions. In sum, it

looks as though it will be impossible for any

financial services firm to entirely insulate itself from the economic repercussions of the

millennial date change. At a minimum, some

adverse economic effects are likely to be felt

within the financial services sector, including the FCS and its customers. Every financial institution faces a series of risks associated with the millennial date change in its

computer systems; embedded systems; supplier, client, and servicer interfaces; customer

relations and related ripple effects; infrastructure, and government services. Failure to

address each area of risk successfully can

increase the potential for legal liability. FCA

has provided and will continue to provide

timely and comprehensive guidance to System institutions at both the general and individual institution levels. Institutions may

be able to mitigate their liability exposure if

they follow FCA’s Y2K guidance and can

document that they did so.

Another article focuses on the importance

of agricultural exports and the effects of the

decline in Asian economies on American

agriculture. Over the last three years Asian

markets have absorbed about 48 percent of

U.S. export value. A quantitative model

shows how alternative scenarios for Asian

growth might affect the 1998-2002 forecast

for farm income, real estate values, and debt

for the Nation and for each Farm Credit district. Significantly, in the Baseline forecast

the strong mid-1990s growth in real estate

prices is forecast to reverse in 1999. In fact,

prices are predicted to decline slightly in 1999

and remain weak through the forecast period—more so in the Asian Depression scenario. Fortunately, unless the Asian Depression scenario comes to full fruition, the worst

stresses will be localized and short-lived compared with those of the 1980’s.

3
FCA 1998

Mid-Year Report

This report also contains the Agency’s Regulatory Performance Plan for Fiscal Year 1999.

The plan provides a brief description of each

regulatory project intended for development

in the upcoming fiscal year.

The FCA will sponsor a symposium in December to highlight some of the more critical and timely aspects of loan portfolio management. The symposium will provide a

forum for discussing risk-related management issues associated with agricultural lending. Key topics such as management information systems, portfolio stress testing, and

environmental risk evaluation will be discussed. The symposium is structured for

System personnel including chief executive

officers, chief credit officers, and others involved in the credit function.

This Mid-Year Report provides an overview

of trends in the System’s corporate restructuring activities. As of October 1, 1998, there

were 201 System banks and associations -13

fewer than existed a year earlier. The most

significant decline was in the number of

Federal Land Bank Associations (FLBAs),

which dwindled by nine to 40 as a result of

mergers in the Texas District and the formation in the Wichita District of direct lender

Federal Land Credit Associations (FLCAs).

FLBAs affiliated with the Farm Credit Bank

of Texas also are expected to begin the transition to FLCAs by mid-1999, assuming

shareholders approve the Bank’s proposed

plan to transfer direct lending authority.

There have been no mergers among the eight

Farm Credit banks in the System since April

1995.

On July 14, 1998, the FCA Board adopted a

philosophy stating its belief that “unrestricted

intra-System competition is beneficial for the

customer and the long-term relevancy of the

Farm Credit System.”

September 25, 1998

4
FCA 1998

Mid-Year Report

Financial Performance of the Farm Credit

System for the First Half of 1998

Laurie Hopkins and Andrew Jacob

a financial cushion because of weather or

other problems are likely to experience loan

repayment problems in 1998. The main issues facing the agricultural economy are discussed below.

Adverse weather conditions will lead to

poor crop yields or crop failure in

several states.

The Southern drought, extreme heat and

drought in Texas, spring floods and crop

disease in the Northwestern Plains, and unseasonably wet and cool weather in California have altered expected crop production

in these areas significantly. For example,

difficult weather conditions in Texas and

Oklahoma will cut this year’s domestic cotton crop by 25 percent, lowering overall output and raising prices. In the Northern Plains

the poor growing conditions (spring flooding) and diminished yields of 1997 have

spilled over into 1998 and left producers with

mounting financial problems. Conversely,

other areas of the United States have experienced favorable weather conditions, and

overall harvests of corn, soybeans, and wheat

will be at or very near record levels, which is

likely to further depress prices.

Commodity prices are falling under

the weight of near record harvests and

faltering demand.

Increased worldwide supply paired with

weaker export demand has depressed commodity prices significantly for U.S. farmers.

Prices were quite favorable in 1995, 1996, and

much of 1997, and stocks were low. Chart 1

depicts the relationship between favorable

commodity prices and low stock levels for

corn, which is the same trend seen for wheat

and soybeans. The favorable prices were

strong signals to increase production. Expansion also was fueled in part by confidence

that exports to Asian markets would continue to grow. However, an increase in foreign competition from Argentina, Brazil, and

Australia and solid U.S. yields have contribOverview: Farm Credit System

Posts Solid Financial Results, While

Stress in the Agricultural Economy

Points to Risks on the Horizon

The Farm Credit System’s solid financial results for the first half of 1998 do not reflect

the stress associated with increasingly difficult agricultural economic conditions. With

continued adversity, however, the quality of

the Farm Credit System loan portfolio may

decline, which in turn may reduce the strong

financial performance it has realized during

most of the 1990’s. However, in anticipation

of the downturn in agriculture, the System

has built its risk bearing capacity to withstand this adversity.

Agricultural Economy: Increasingly

Difficult Conditions in Mid-1998

Despite an overall robust U.S. economy and

a period of strong net farm income throughout most of the 1990’s, concerns have developed about recently falling commodity

prices, declining net farm income, and difficult weather conditions. Corn, wheat, soybeans, hogs, and cattle are the most seriously

stressed commodities because of the downturn in current economic conditions. Most

producers entered 1998 in a fairly strong financial position that will serve as a crucial

cushion for many of them. In 1997, farmers

and ranchers experienced a turnaround in

the cattle industry and near record crop harvests, which brought widespread profits.

Debt loads have not risen to burdensome

levels overall partly because many farmers

have opted to pay down loans rather than

incur increased debt. A recent U.S. Department of Agriculture (USDA) study showed

that the number of highly leveraged farms

with debt/asset ratios above 70 percent was

about 4 percent at the end of 1997. This is

consistent with levels observed during the

previous 5 years but well below the level

observed during the mid-1980’s, when 10

percent of the farmers were in this category.

However, farmers who ended 1997 without

This article reviews the increasingly difficult conditions in the agricultural economy.

In addition, components of the System’s

financial condition are assessed with emphasis on commodity concentrations in each

Farm Credit System district.

4
FCA 1998

Mid-Year Report

uted to the rapid decline in commodity

prices. Although China is also an important

foreign competitor, poor weather has recently

affected its agricultural production. Depressed prices have reduced the value of U.S.

exports even though the volume of commodity and red meat exports was up from

October 1997 to June 1998.

For wheat, corn, soybean, cattle, and hog

producers, prices are substantially lower than

they were during 1997. Unfortunately, USDA

expects season average prices for 1998–99 for

these commodities to be even lower than for

the 1997–98 season. Farmers are preparing

to bring in the largest soybean crop, the second largest corn crop, and among the largest

wheat crops ever, which portends continued

price weakness for these grains. Meat production has also increased so that hog prices

have been low all year long and cattle prices

have begun to weaken recently. Conversely,

strong demand for certain dairy products,

such as butter, cheese, and milk fat, has supported milk prices, although the patterns

have been uneven due to erratic milk supplies.

Net farm income for 1998 is forecast to

decline by 15.8 percent.

As of late September, the USDA had lowered

its forecast of net farm income largely because of declining commodity prices. As

shown in Chart 2, the USDA reduced the

1998 forecast by $ 7.9 billion from 1997 and

$11.5 billion from the 1996 record. Yet it is

up $5.9 billion from 1995 and is 7.3 percent

below the average for the 1990’s. Direct government payments are forecast by USDA to

be $7.4 billion for 1998, slightly lower than

1997 and the average for the 1990’s. However, this forecast will be reversed upward

because government loan deficiency payments will increase substantially as commodity prices fall. Throughout the 1990’s direct

government payments have averaged 19.2

percent of net farm income, assisting producers during the particularly difficult years

of 1991, 1995, and now 1998.

Chart 1

Corn Stocks/Use Ratio and Price

as of 3/1/98

Source: Agricultural Outlook, Economic Research Service, U.S. Department of Agriculture

6
FCA 1998

Mid-Year Report

Government assistance will help

alleviate some financial hardship for

troubled farmers.

The Federal government has launched an

assistance package to mitigate the weatherrelated stresses affecting many farmers. Immediate initiatives include a lifting of sanctions against foreign grain sales and a $250

million wheat purchase funded by the Commodity Credit Corporation that aims to raise

prices and fulfill a humanitarian need in the

form of food relief overseas. Other solutions

involve moving $5.5 billion in crop support

payments from 1999 to late fall 1998, and

about a half billion dollars in low interest rate

loans to alleviate financial pressures of some

of the hardest hit farmers. In addition, commodity prices have fallen below the USDA

loan price support level, especially for wheat

and corn producers. Depending on how long

this condition exists, several billion dollars

in loan deficiency payments may be made to

farmers by the USDA in the coming months.

Farm Credit System Financial

Performance: Ability to Withstand

Risks on the Horizon

The Farm Credit System’s financial performance during the first half of 1998 was solid

despite the challenging aspects of the agricultural economy. The Farm Credit System

has been able to maintain loan volume

growth and a high quality loan portfolio,

which has sustained strong earnings. Earnings have helped build the System’s capital

position to healthy levels, thereby improving

risk-bearing ability. However, commodity

concentrations represent a continued source

of risk.

Loan volume has grown significantly,

particularly for both short- and

intermediate-term loans.

The Farm Credit System’s loan portfolio (including cooperative lending) grew 4.8 percent for the period June 30, 1997, to June 30,

Chart 2

Total Net Farm Income, 1990-1998

as of September 24, 1998

P= Preliminary A=Average of time period F=Forecast

Source: Derived from Economic Research Service data, U.S. Department of Agriculture In Billions

7
FCA 1998

Mid-Year Report

1998. During this period, total loans

increased from $62.6 billion to $65.6 billion.

The $3 billion increase was concentrated in

long-term real estate and short- and intermediate-term loans, while domestic loans to

cooperatives and export financing fell. Chart

3 indicates that the increase in loan volume

was led by short- and intermediate-term

loans, which jumped 11.6 percent, growing

from $16 to $17.8 billion. Long-term real

estate loans increased 4.6 percent, from $30

to $31.4 billion. The continued upsurge in

farmland values contributed to the growth

in long-term real estate loans collateralized

by farmland, including those used for purposes other than the purchase of land. However, farmland values may be stalling in some

regions because net farm income is expected

to decline. Diminishing direct government

payments under the 1996 Freedom to Farm

Act will also limit upward pressure on land

values. If farmland values begin to level off

or even fall, lenders will likely reduce real

estate lending in the near future. The rise in

short- and intermediate-term loans is consistent with the significant growth shown in

this area during the same periods in 1995

and 1996. The recent upsurge of short-term

loans may be partly attributable to farmers

choosing to store crops and borrow more

for operating expenses. By District, non-realestate loan growth was particularly robust in

the AgAmerica District, up 20.4 percent,

while long-term real estate lending showed

significant growth of 19.3 percent in the

Western District.1

Domestic loans to cooperatives fell from

$14.4 billion to $14.3 billion for the 12-month

period ending June 30, 1998. This area led

the Farm Credit System for increases in loan

volume during the same periods of 1995 and

1996, but declined in 1997 and in 1998.

Cooperatives have required fewer funds because of low commodity prices, weak demand, and increased storage of crops by

producers. Loans made in connection with

international transactions declined 8.6 percent, from $2.3 billion to $2.1 billion, because

of on-going loan pay-downs, continuing a

trend that began in 1995.

Long-term agricultural real estate loans are

the predominant portion of the Farm Credit

Banks and associations’ loan portfolios (see

Chart 4). These loans are collateralized by

real estate and are used to finance farmland,

farm buildings, and other longer-term capi1. A District is a Farm Credit System bank (i.e., Farm Credit Bank or

Agricultural Credit Bank) combined with its affiliated associations

with the exception of St. Paul Bank for Cooperatives. Districts are

referenced throughout by Farm Credit System bank name as follows: AgAmerica, AgFirst, AgriBank, Texas, Wichita, Western, and

CoBank.

8

Chart 3

FCS Loan Portfolio: Percent Change from

Second Quarter of Previous Year as of June 30, 1998

Source: Derived from FCA Report to Investors
FCA 1998

Mid-Year Report

tal needs. Non-real-estate loans provide

short-term working capital needs for crop

production and intermediate-term loans for

equipment and other similar capital goods.

These two loan types accounted for 93.1

percent of loans made by Farm Credit Banks

and associations as of mid-year 1998, little

changed from the average of 93.0 percent

during 1994–1997.

Commercial bank agricultural loan

growth outpaced the Farm Credit

System’s loan growth.

Over the past decade, commercial banks have

competed effectively with the Farm Credit

System, capturing an increasing market share

of agricultural loans. Recent data show that

growth in commercial banks’ agricultural

loans has outpaced Farm Credit System

growth for the last four quarters, as shown

in Chart 5. From March 31, 1997, to March

31, 1998, commercial bank farm loans increased 9.8 percent, the highest percentage

growth rate of the 1990’s.2 At March 31, 1998,

commercial bank farmland and agricultural

production loans outstanding reached $69.9

billion. Much of the growth has come from

traditional commercial agricultural banks,

which showed an 11.6 percent increase in

combined farmland and agricultural production lending for the past year. As of March 31,

1998, there were 2,327 commercial agricultural banks.3

Loan volume at Farm Credit Banks and

associations grew.

Loan growth varied widely by District, with

the greatest percentage growth observed in

AgriBank and AgAmerica Districts (see

Chart 6). From June 30, 1997, to June 30,

1998, loans outstanding in these two Districts

increased about 10.0 percent compared to a

more moderate 3.5 percent loan growth in

the Wichita District. The CoBank District

(which includes lending by affiliated associations in the Northeast and to agricultural

cooperatives) experienced a slight decline of

0.7 percent due to less borrowing by domestic cooperatives. The St. Paul Bank for Cooperatives (St. Paul BC) had a significant

decline of 12.4 percent in loan volume. Many

direct lender associations posted solid growth

Chart 4

Distribution of Loans

(excluding cooperatives and international)

as of June 30, 1998

Source: Loan Account Reporting System (LARS)

2. First quarter 1998 data is used in this discussion because the

commercial bank Call Report data is derived from Sheshunoff Information Services, which does not release its second quarter

1998 data until late September.

3. As defined by the Federal Deposit Insurance Corporation (FDIC), a

commercial agricultural bank is a bank with total agricultural loans

in excess of 25 percent of its total loan portfolio.

9

Chart 5

Commercial Banks Agricultural Loan Growth Recently Surpassed Farm

Credit System Loan Growth (excluding cooperatives and international)

Source: Derived from Sheshunoff Bank Search and LARS Data, which excludes rural home, farm related business,

processing, and marketing, aquatic, and other.
FCA 1998

Mid-Year Report

from June 30, 1997, to June 30, 1998. During

this period, total loans outstanding grew by

more than 10 percent at 46 associations, and

15 associations experienced a growth rate in

excess of 20 percent.

The Farm Credit System has significant

concentration in stressed commodities.4

As a single industry lender, the Farm Credit

System has significant exposure to the

stressed U.S. agricultural economy. Loan

portfolio concentration in certain stressed

commodities, especially wheat, corn, soybeans, hogs, and cattle, is an indication of

where difficulties may appear. Evidence of

problems may appear in the form of increased delinquencies after the marketing

year has passed. As a group, all Farm Credit

Banks and associations have the highest

commodity concentrations in corn loans at

10.3 percent, dairy loans at 10.2 percent, and

beef cattle and cattle feedlot loans at a combined 11.4 percent (see Chart 7). However,

individual Districts have different concentration exposures to stressed commodities and

related risk.

The Texas District may experience an increase in loan problems because of its concentration in cattle loans, representing 33.8

percent of the loan portfolio (see Chart 8).

Despite this concentration, the prevalence of

part-time cattle producers in the area may

mitigate overall difficulties. Cotton loans,

which constitute 14.4 percent of the portfolio, are vulnerable due to the extreme drought

that has ravaged the area’s production.

Chart 6

Loans Outstanding Grew in Most Districts 2nd Quarter 1997 Compared

with 2nd Quarter 1998

Source: Summary Report of Condition and Performance of the Farm Credit System In Billions

4. A loan is assigned to a specific commodity category if 50 percent

or more of the borrower’s loan value is concentrated in a given

commodity. The charts represent commodity concentrations according to three qualifications. First, the top three commodities

by total loan concentration were selected for each District. Second, seven major commodity categories (corn, wheat, soybeans,

cattle, dairy farms, hogs, and cotton) were selected and highlighted

if the category represented 2.5 percent or more of loan volume.

Last, the ‘other*’ category captures all commodities that did not

meet the first two requirements, and all concentrations that represent 8 percent or less of loan volume. Concentration data was

derived from the Loan Account Reporting System (LARS) and does

not include cooperative lending. Underlying loan diversity is

greater than the data suggests because each borrower is categorized by only the major commodity produced. Typically, farmers

and ranchers are diversified through the production of more than

one commodity. Nevertheless, the LARS data is a mechanism for

identifying regions with a high degree of concentration in stressed

commodities.

Chart 7

Farm Credit System: Sampling of

Major Commodity Concentrations

as of June 30, 1998

Total FCS Loans: $48.6 billion

Chart 8

Texas District

as of June 30, 1998

Gross Loans: $4.1 billion

10
FCA 1998

Mid-Year Report

Chart 9

Western District

as of June 30, 1998

Gross Loans: $5.5 billion

Chart 10

Wichita District

as of June 30, 1998

Gross Loans: $3.9 billion

The Western District’s loan portfolio shows

concentrations in grape loans at 16.1 percent, dairy farming at 14.9 percent, and tree

nuts at 8.1 percent (see Chart 9). Hence, the

performance of the Western District’s overall portfolio is less likely to be affected significantly by weaknesses in the agricultural

economy given its loan diversity and lack of

concentration in any of the major stressed

commodities. However, reduced export demand for fruits and vegetables and recent

adverse weather may cause difficulties for

many producers.

In the Wichita District, stressed commodities (cattle, wheat, corn, and soybeans) constitute 59.6 percent of the loan portfolio. The

financial health of the producers of these

commodities is especially vulnerable and

may cause future deterioration in the quality

of the loan portfolios in the Wichita District

(see Chart 10).

CoBank’s loans to producers in the Northeast have a heavy concentration in dairy

farms (39.1 percent) along with lesser concentrations in ornamental floriculture at 11.2

percent and berry crops at 5.3 percent (see

Chart 11). Dairy producers in this district

may be bolstered by the decline in feed prices

and continued strong demand for dairy

products.

Loan concentrations in the AgFirst District

are evenly distributed among producers of

broiler/fryers, beef cattle, and dairy at approximately 9 percent each. As a result, the

loan portfolio shows substantial diversity and

lack of concentration in troubled commodities, which serve to mitigate negative economic impacts on the area (see Chart 12).

The AgriBank District, which straddles the

Northern Plains and the Corn Belt, may

encounter stress because of its 33.6 percent

concentration in corn, wheat, cash grain, and

soybean loans, and another 6.8 percent in

Chart 11

CoBank District

as of June 30, 1998

Gross Loans: $1.9 billion

Chart 12

AgFirst District

as of June 30, 1998

Gross Loans: $8.8 billion

11
FCA 1998

Mid-Year Report

hog loans (see Chart 13). Prices for these

commodities are forecast to remain weak.

However, dairy loans represent 12 percent of

total loan volume, and these loans will likely

benefit from a stronger dairy market.

The AgAmerica District has its highest loan

portfolio concentration in corn at 14.2 percent, beef cattle at 10.0 percent, and wheat at

8.1 percent, all of which face falling prices

(see Chart 14). However, AgAmerica shows

loan portfolio diversity and overall low concentrations, which should dampen the effects

of declining prices in certain commodities.

Asset quality currently remains at a

high level.

The Farm Credit System’s loan portfolio remains in solid condition as measured by

credit classifications in relation to risk funds

and nonperforming loan statistics. The high

quality of the loan portfolio has been responsible for the excellent financial performance

by Farm Credit System institutions. Furthermore, strong financial performance has built

risk-bearing ability through capital growth

and strong earnings. As a result, the Farm

Credit System is in a good position to withstand the emerging risks from a deteriorating agricultural economy. While these risks

are not currently apparent when viewing

early warning indicators such as delinquencies, credit classifications, or provision for

loan losses, continued poor weather and low

commodity prices may lead to some deterioration in loan portfolio quality by the end

of 1998.

Credit quality slightly improved.

As shown in Chart 15, credit quality for Farm

Credit System banks and associations has

improved slightly over the past several years.

Acceptable loans have reached 89.2 percent

of total loan volume5 while the level of Other

Assets Especially Mentioned (OAEM) and

adversely classified loans have remained relatively steady at approximately 6 and 5 per5. All credit classification ratios include accrued interest receivable.

Loans classified OAEM exhibit potential weaknesses and adverse

financial and operational trends that have yet to impact repayment. Compared with the acceptable and OAEM classifications,

adversely classified loans are loans with greater repayment risk

and where collection in full is a concern. Adversely classified

loans represent the sum of loans classified Substandard, Doubtful, and Loss.

Chart 14

AgAmerica District

as of June 30, 1998

Gross Loans: $7.5 billion

Chart 13

AgriBank District

as of June 30, 1998

Gross Loans: $16.9 billion

12
FCA 1998

Mid-Year Report

cent of the portfolio, respectively. All Districts maintained asset quality at high levels,

with most reporting some improvements.6

While still at a high level, AgriBank’s asset

quality fell slightly as the level of loans classified acceptable dropped to 88.2 percent of

total loans at June 30, 1998, compared with

91.9 percent a year earlier. The AgriBank

District experienced a corresponding increase in loans classified OAEM, which indicates potential future weaknesses and adverse

financial trends for borrowers. These weaknesses are partly attributable to weather and

other related problems with crop production

experienced over the past few years. Although asset quality was strong overall, the

St. Paul BC exhibited weaker asset quality

relative to other Farm Credit System banks.

Asset quality of direct lender associations

remained relatively stable from June 30, 1997,

to June 30, 1998. The number of direct lender

associations with adverse assets in excess of

10 percent of total loan volume and other

property owned (OPO) dropped from 15 to

10 associations.7 However, the number of

direct lender associations with adverse assets

to total loans ranging from 5 to 10 percent

increased by 9, to 50 associations. Most of

the increase was with several associations that

moved to just above the 5 percent level. At

June 30, 1998, the Farm Credit System had

147 direct lender associations.

Capital and allowance for loan losses

positions were sufficient compared

with portfolio risk.

On a combined basis, Farm Credit System

banks and associations have sufficient capital and allowance for loan losses in relation

to the level of adverse assets. Adverse assets

represented 25.2 percent of capital and allowance for loan losses at June 30, 1998, compared with 26.7 percent at June 30, 1997.

As of June 30, 1998, only 3 associations had

adverse assets to risk funds (permanent capital and allowance for loan losses) exceeding

50 percent, a drop from 11 associations a year

earlier. None were in excess of 66 percent.

Adverse assets to risk funds greater than 50

percent is an indicator of greater risk levels

relative to risk-bearing ability. However, 39

associations had a ratio between 30 and 50

percent, compared with 27 associations a year

ago. 6. Districts were defined in footnote 1. St. Paul BC is not considered

a District because it has no affiliated associations.

7. Adverse assets are adversely classified loans and OPO.

8. Nonperforming assets are nonaccrual loans, accruing restructured

loans, accruing loans 90 days or more past due, and OPO.

Chart 15

Combined System Banks and Associations Quality Improved Slightly

as of June 30, 1998

Source: Summary Report of Condition and Performance of the FCS

13
FCA 1998

Mid-Year Report

association level, 10 associations reported

nonaccrual loans in excess of 1.75 percent of

gross loans compared with 27 associations

at June 30, 1997. Risk funds coverage of

nonaccrual loans was sufficient considering

the ratio of nonaccrual loans to risk funds of

13 percent at June 30, 1997, and 11 percent at

June 30, 1998.

The level of loans 90 or more days delinquent and still accruing interest has been

stable and has remained low. The level has

remained at around 0.1 percent for the Farm

Credit System on a combined basis and for

the individual Districts. Similarly, accrual

loans 30 or less days delinquent have remained below 1.0 percent for the past several years.

Adequate allowance for loan losses

bolsters the System’s risk bearing

ability.

The level of the allowance is consistent with

the Farm Credit System’s loan volume growth

and expected risks emanating from the loan

portfolio. However, if commodity prices remain low and adverse weather conditions

continue, asset quality may deteriorate and

the Farm Credit System may have to increase

the allowance. Allowance for loan losses was

Nonperforming loans have declined as

a percentage of total loans.

Along with a high level of asset quality, the

Farm Credit System’s nonperforming assets

position has improved.8 Nonperforming assets were 1.3 percent of total loans at June 30,

1998, compared with 2 percent a year earlier

(see Chart 16). The Farm Credit System’s

level of nonperforming assets is comparable

to the level for commercial agricultural banks,

which was 1.2 percent at March 31, 1998. The

level of nonperforming assets improved significantly because of the resolution of several large loans to domestic cooperatives.

Capital and the allowance were sufficient

relative to the level of nonperforming assets.

At June 30, 1998, nonperforming assets were

6.2 percent of capital and allowance for loan

losses, a significant decline from 9.9 percent

at June 30, 1997.

The improvement in nonperforming assets

came mainly from continued reductions in

nonaccrual loans. At June 30, 1998, the Farm

Credit System’s level of nonaccrual loans represented 1.0 percent of total loans. By District, the level of nonaccrual loans to total

loans ranged from a low of 0.8 percent to a

high of 2.1 percent compared with a range

of 1.0 to 5.4 percent a year earlier. At the

Chart 16

Trends in Nonperforming Assets

as of June 30, 1998

Source: Report to Investors, Quarterly Information Statement

14
FCA 1998

Mid-Year Report

$1.9 billion at the end of the second quarter

and represented 2.8 percent of total loans.

The allowance has remained around 2.8 percent over the past 4 years, higher than the

2.0 percent for commercial agricultural

banks. The Farm Credit System’s higher allowance is appropriate because commercial

agricultural banks are able to diversify their

loan portfolios in economic sectors other

than agriculture. Allowance accounts are

maintained through the provision for loan

losses on the income statement. The provision expense for the first 6 months that ended

June 30, 1998, was $32 million, down significantly from $67 million for the 6-month

period that ended June 30, 1997, and $57

million for the 6-month period that ended

June 30, 1996. The trend in the provision for

loan losses indicates that the quality of the

loan portfolio does not require any buildup

in the allowance.

Investments increase to meet liquidity

and interest rate risk needs

Each Farm Credit System bank maintains an

investment portfolio primarily for liquidity

purposes. The investment portfolio consists

of highly rated, guaranteed, mortgage-backed

securities, asset-backed securities, corporate

debt, and short-term securities such as commercial paper, negotiable certificates of deposit, and Federal Funds sold. On June 30,

1998, the investment securities totaled $12.7

billion and represented 16.2 percent of total

assets. This compares with investments totaling $11.8 billion and 15.5 percent of total

assets on June 30, 1997. The growth in investments is attributable to increased liquidity needs due to discount note funding and

additional use of investments to help manage interest rate risk exposures. By regulation, the size of each Farm Credit System

bank investment portfolio is limited to 30

percent of gross loans.

Capital growth builds the Farm Credit

System’s risk-bearing capacity.

Farm Credit System capital totaled $12.2

billion on June 30, 1998, compared with $11.1

billion a year earlier. The Farm Credit System has significant capital levels to assist in

guarding against risks emanating from the

stressed agricultural economy. For the 12-

month period ending June 30, 1998, total

Chart 17

Risk Bearing Ability Improved

Source: Report to Investors, Quarterly Information Statement

In Billions

15
FCA 1998

Mid-Year Report

9. Assets in the Insurance Fund and the capital related thereto are

designated as restricted assets and restricted capital, respectively.

The classification of the Insurance Fund as restricted capital is

based on the statutory requirement for the amounts in the Insurance Fund, which is under the control of the Farm Credit System

Insurance Corporation, and is to be used solely for the purposes

specified in the Farm Credit Act of 1971, as amended, all of which

benefit System institutions directly or indirectly.

10. For the Farm Credit System, the major components of capital are

surplus, capital and participation certificates, restricted capital,

and accumulated other comprehensive income.

11. A basis point is 1/100 of 1 percent.

capital increased by $1.1 billion due to continued strong earnings performance. Despite

an increase in assets, capital has increased as

a percentage of assets to 15.1 percent, up from

14.5 percent at June 30, 1997 (see Chart 17).

Excluding restricted capital, the ratio of capital to assets was 13.7 percent at June 30, 1998,

compared with 13.1 percent at June 30, 1997.9

At June 30, 1998, total capital included $8.8

billion in surplus, up from $7.9 billion a year

earlier.10 Similarly, the level of capital stock

and participation certificates was $1.9 billion,

virtually unchanged from a year earlier, while

restricted capital increased to $1.4 billion

from $1.2 billion a year earlier. Accumulated

other comprehensive income, associated primarily with unrealized gains and losses on

investments, was $38 million compared with

$15 million a year earlier.

The FCA requires each institution to maintain a minimum of 7 percent permanent

capital to risk-adjusted assets; 7 percent total

surplus to risk-adjusted assets; and 3.5 percent core surplus to risk-adjusted assets ratio. As of June 30, 1998, two institutions were

not in compliance with the Agency’s core

surplus requirement. However, these institutions are operating under Agency-approved capital restoration plans, which puts

them in technical compliance with the capital regulations.

Earnings remain strong despite a

tightening in interest spreads.

For the first 6 months of 1998, the Farm

Credit System’s net income was $666 million, up $59 million from the same period

last year. The gain was attributable to increased loan volume, higher capital levels,

and stable funding costs. Interest-free funds

(capital invested in interest earning assets)

increased by $1 billion due to earnings retention (see Chart 18). The increase in interest free funds helped offset the 20-basispoint-reduction in the net interest spread

(rate on earning assets minus the rate on

interest bearing liabilities) experienced since

June 30, 1996. 11 As a result, the net interest

margin remained close to 3 percent over the

past 4 years. The Farm Credit System posted

a healthy 2.92 percent net interest margin at

June 30, 1998, compared to 2.90 percent 1

Chart 18

Spreads Tighten but Net Margin Stays Strong due to Higher Capital Levels

Source: Report to Investors, Quarterly Information Statement Rates (%)

16
FCA 1998

Mid-Year Report

Chart 19

Mid-Year Profitability Remains Strong

Source: Derived from Report to Investors, Quarterly Information Statement Return on Average Assets (%)

Return on Average Equity (%)

year earlier and 3 percent 2 years earlier. In

the future, profitability may come under some

pressure as provisions are made to the allowance to reflect agricultural economic weaknesses.

Profits remain strong.

Since 1995, the Farm Credit System has consistently posted an annualized return on average assets (ROAA) in excess of 1.6 percent

for the first 6 months of each year. At June

30, 1998, the annualized ROAA was 1.68

percent compared with 1.61 percent for June

30, 1997, and 1.81 percent for June 30, 1996

(see Chart 19). Similarly, the annualized return on average equity (including restricted

capital) was 11.25 percent at June 30, 1998,

compared with 11.19 percent for June 30,

1997.

Uncertainty exists with regard to interest rate

stability given the Asian and Russian economic crisis. Currently the Federal Reserve

has chosen to maintain interest rates which

has stabilized the Farm Credit System’s cost

of debt. However, the spreads between Farm

Credit System debt securities and U.S. Treasury securities have been widening due to

reduced Treasury issuance during a period

of strong investor demand. U.S. Treasury

issuance is down due to the budget surplus

resulting from strong U.S. economic performance. Investor demand has increased from

uncertainties associated with the Asian economic crisis and the recent Russian currency

devaluation and debt default. This global uncertainty has generated a flight-to-quality to

U.S. Treasury securities and pushed rates on

such securities to very low levels. Similarly,

the swap debt curve has widened compared

to U.S. Treasury securities, which has put

further pressure on Farm Credit System

spreads, particularly for intermediate- and

long-term securities. For example, spreads

on 10-year, fixed-rate securities had widened

to 63 basis points by September 1, 1998, compared with 29 basis points at the end of January 1998.

17
FCA 1998

Mid-Year Report
FCA 1998

Mid-Year Report

The Farm Credit Act has always granted taxexempt status for income generated by mortgage lending by Farm Credit Banks (FCBs),

Federal Land Bank Associations (FLBAs),

and Federal Land Credit Associations

(FLCAs). In contrast, income generated from

production and cooperative lending by Production Credit Associations (PCAs) and

Banks for Cooperatives (BCs) is not taxexempt. This distinction was simple when

there were only a few types of System institutions and their lending activities were

clearly distinguished as either short-term

(agricultural operations), long-term (agricultural mortgages), or cooperative (cooperative loans) lending operations. After 1987,

the structure of System institutions began to

change. Institutions merged in order to

achieve operating efficiencies, to provide

“one-stop” shopping for their borrowers, or

simply to pool scarce capital.

The creation of Agricultural Credit Associations (ACAs) through mergers of PCAs and

FLBAs or FLCAs raised the question of

whether the tax exemption for income generated from mortgage lending extends to

ACA mortgage portfolios. Congress did not

address this issue in the 1987 Amendments

to the 1971 Act, and a number of institutions chose not to form ACAs because of

uncertainty over this issue. In 1996, when

the issue was raised to the national office of

the Internal Revenue Service (IRS), the IRS

issued a memorandum advising that, in the

absence of an express statutory exemption

from taxation, ACAs should be considered

fully taxable.

In 1997, the Farm Credit System made provisions of $186 million for income taxes on

$1,453 million in income for an effective tax

rate of 13 percent, compared with a statutory tax rate of 35 percent for C corporations. The System estimates that it would

have paid an effective rate of 21 percent ($104

million more1

) had not 61 FCSIs elected to

file under Subchapter T of the IR Code.

Background

Taxes are an inescapable and necessary cost

of doing business in this country. Oliver

Wendell Holmes once said, “Taxes are the

price we pay for a civilized society.” Most of

us would agree that the taxes we pay provide

a great environment in which to live. Most

of us would agree that we are willing to pay

our fair share of the cost of maintaining our

society. But most of us would also agree that

we do not want to pay more than our fair

share. Determining our fair share can be

difficult and costly process, and the cooperative banking system presents an especially

complicated picture.

Organizational structure affects tax obligations. According to the U.S. Department of

Commerce, American businesses generally

take one of six common organizational

forms: sole proprietorships, partnerships,

limited liability companies, cooperatives,

Subchapter S corporations, and general business (or Chapter C) corporations. Of these,

only Chapter C corporations are required to

pay income taxes at both the corporate and

the individual-owner level. More and more

American businesses are discovering ways to

avoid double taxation. In 1997, only 1 of 10

businesses in the United States operated as a

C corporation.

FCSIs, as cooperatives, fall into three tax filing categories: They may be tax-exempt; file

as C corporations under Chapter 1, Subchapter A, of the Internal Revenue Code (IR

Code); or file as cooperatives under Subchapter T of the IR Code. Out of 203 FCS associations, approximately 32 percent pay corporate taxes as C corporation filers. The rest

are either tax-exempt (38 percent) or take

advantage of Subchapter T rules (30 percent)

to pass earnings through to shareholders as

patronage dividends and forgo paying corporate taxes on that income. Table 1 shows

the breakdown of FCSI filing status as of

January 1, 1998.

Federal Income Tax Options Available to

FCSIs and Their Competitors

Linda Sherman and Robert Andros

Table 1

Tax Filing Status of Farm Credit

System Institutions

January 1, 1998

Institutions

Tax Filing Status Number Percent

Taxable, Subchapter T 61 30

Taxable, Subchapter C 65 32

Tax-exempt 77 38

Total 203 100

This article examines the tax implications

of various organizational structures available

to Farm Credit System institutions (FCSIs)

and their commercial bank counterparts. We

look at the rapid increase in use of Subchapter S by commercial banks, the current use

of Subchapter T by the FCSIs, and compare

the financial implications of each. Finally,

we examine the combined tax effects for the

bank and the borrower, and analyze the total

tax effect of various organizational structures

to the ultimate beneficiary, the farmer.

1. “Farm Credit System: Annual Information Statement-1997,” Federal Farm Credit Banks Funding Corporation. February 25, 1998.

Page F-28.

19
FCA 1998

Mid-Year Report

Recently many commercial banks received

an opportunity to avoid double taxation, at

both the corporate and the shareholder level.

The Small Business Job Protection Act of

1996 gave certain financial institutions the

option of converting to Subchapter S corporations for the first time. A Subchapter S

corporation, like a partnership, is generally

not subject to Federal income tax at the corporate level, passing its income and expenses

through to its shareholders in proportion to

their stock ownership. This option reduces

the bank’s taxes and increases after-tax earnings, much like the Subchapter T option.

By September 1997, the Federal Deposit

Insurance Corporation (FDIC) reported that

585 commercial banks had converted to

Subchapter S, saving themselves an estimated

$190 million in taxes. As of March 1998,

over 400 more banks had converted. Today

over 1,000 banks, ranging in assets from $12

million to $1.2 billion, or about 10 percent

of all commercial banks, claim Subchapter S

status. Since, only 58 banks filed Subchapter

S tax returns for tax year 1995, this represents a significant increase over the past three

years. Many of these commercial banks are

small rural banks that will pass their tax savings on to their owners and customers, increasing the competition for FCSIs that compete for some of the same loans. Figure 1

shows the distribution of Subchapter S banks

by state as of March 31, 1998; most are located

in the central states, with the heaviest concentrations in Minnesota (146) and Texas

(144).

Figure 1

Number of Commercial Banks filing under Subchapter S

as of March 31, 1998

Source: FDIC

20
FCA 1998

Mid-Year Report

Business Structures and Taxation

The sole proprietorship is the most commonly used organizational structure for

American businesses. Its advantages are

simplicity and single-level taxation. Its primary disadvantage is the potential legal liability to which the proprietor is exposed.

Taxes are computed by totaling gross income

from all sources and subtracting deductions

to arrive at adjusted gross income (AGI).

Taxable income is computed by subtracting

itemized or standard deductions from AGI.

Taxable income is then subjected marginally to income rates ranging from 15 to 39.6

percent, the latter rate being imposed for annual income in excess of $271,000.

The partnership is another common organizational structure employed by U.S. businesses. Like a sole proprietorship, it is simple

in form. Its income and expenditures flow

through to the partners, who are taxed at

the individual level. Its primary disadvantage is the potential legal liability to which

the partners are exposed. The partnership

files an informational return explaining the

allocation of income and deductions among

the partners. Income and deductions are

then shown on the individual income tax

return, where the actual tax due is computed.

The limited liability company (LLC),

although a relatively recent innovation, is

now a common form of business organization. These state-chartered entities provide

their owners with the limited liability of a

corporation and the single tax treatment of

a partnership. Pass-through tax treatment

is provided for under Subchapter K of the

IR Code. LLC owners are called members,

as in a cooperative structure, but the LLC is

a state-approved, unincorporated association.

A general business corporation, or C corporation, is the most easily recognized form

of business structure in the world. The C

corporation is an entity separate from its

owners, providing a stable organizational

structure that can outlive its owners as well

as provide them with legal liability protection. The C corporation is subject to income

taxation in its own right. Corporate income

tax rates generally range from 15 to 35 percent, with the higher rates being applied to

taxable income brackets of over $100,000.

Corporation profits distributed to stockholders as dividends are included in their gross

income. Consequently, corporation profits

are subject to taxation at the corporate level

and again at the shareholder level when distributed as dividends.

Subchapter S corporations, named after the

IR Code section that affords them special tax

treatment, are closely held corporations with

fewer than 75 shareholders. Although they

are required to file tax returns like other general business corporations, if they meet certain criteria they can elect to be taxed as a

partnership. Unlike C corporations, these S

corporations are not taxed at the corporate

level. Instead, their income and expense

items are passed through to the shareholders

to be reported on their individual income

tax returns. By electing S status, a corporation may avoid double taxation of income

distributed to its shareholders. The Subchapter S rules also dictate specific levels of cash

payouts for dividends and set forth criteria

for how allocated and unallocated equities

must be recorded on the company’s books.

The Small Business Job Protection Act of

1996 made the Subchapter S filing option

available to commercial banks, offering them

roughly the same advantage of single taxation of dividends that Subchapter T filing

does for cooperatives.

Subchapter T corporations are cooperatives

that, by meeting certain criteria, can exclude

from income patronage dividends paid in

money, property, or qualified written notices

of allocation. The cooperative notifies the

IRS of the dividend payment on Form 1099-

PATR, and the patron is then taxed on that

21
FCA 1998

Mid-Year Report

amount. Distributions are based on the

quantity or value of business done, rather

than on stockholder equity as is the case with

Subchapter S corporations.

Subchapter T applies to any corporation operating as a cooperative, and covers tax treatment of cooperatives and their patrons who

receive patronage dividends. Some

cooperatives, including farmers’ marketing

and purchasing cooperatives, are classified

exempt and are not taxed. However, most

cooperatives, including some FCSIs, are taxed

the same as any ordinary business corporation at regular corporate rates, with the significant exception that cooperatives filing

under Subchapter T may deduct qualified

patronage distributions from income.

The IR Code recognizes that cooperatives

provide services at cost; therefore, refunds of

net margins to patrons are subjected to federal income taxation only once. Patronage

must be allocated based on the quantity of

business transacted with the cooperative, a

preexisting obligation before the earnings

begin, and the net earnings derived from

business conducted with or for the

cooperative’s patrons. Patronage dividends

allocated by the cooperative may be deducted

in calculating its taxable income if the patron

agrees to include the same amount in his or

her income tax liability. This agreement may

be established in any of three ways:

1. Through the cooperative’s bylaws.

2. By written consent signed and furnished

before the end of the taxable year.

3. By endorsing and cashing a qualified

check. A qualified check bears a notice that

endorsing and cashing the check constitutes consent by the patron to include the

patronage dividend as part of his or her

taxable income.

If all taxable earnings are distributed, the

Subchapter T institution pays no taxes and

the borrower/shareholder assumes the total

tax liability. Alternatively, a cooperative may

retain up to 80 percent of its declared

patronage dividend tax-free at the corporate

level. If a non-cash allocation is declared, a

Subchapter T institution must distribute

(allocate) a minimum of 20 percent of the

earnings in cash to defray its shareholders’

anticipated tax expenses. In this case the

patron would pay taxes on the total patronage

dividend, and the FCSI would retain the

allocated portion as a capital investment.2

2. Under Farm Credit Administration (FCA) regulations, this capital

must be retained for more than 5 years for it to be counted as core

surplus. Even then, it cannot be counted as core surplus when

the revolvement cycle declines to 3 years or less. FCSIs may

claim a refund for taxes paid on nonqualified patronage dividends in the year of actual distribution.

Figure 2

FCS Tax Filing Status by District Number of Institutions

22
FCA 1998

Mid-Year Report

tion charges its customers. The actual effect

of an institution’s converting to Subchapter

T status depends on how much of its income

the institution pays in dividends and on the

combined tax rates of the institution and its

various owners. Although it is not a tax

exemption, conversion to Subchapter T status

generally produces a reduction in the combined taxes paid by the institution and its

owners. This article is primarily concerned

with analyzing the tax consequences of using

the different filing methods. It should be

noted that the comparison of tax treatments

demonstrated in Table 2 below makes rather

simplistic assumptions regarding distribution

of income in order to compare the net taxes

paid by both the institution and the patron.

In Table 2, a cooperative doing $10,000 in

business on behalf of its patrons has incurred

$9,000 in expenses and has $1,000 in income

after expenses. It has met all of the requirements for Subchapter T tax filers. It may

issue a qualified written notice of allocation

to its members by sending them $280 (to

cover a 28% personal tax liability) in cash or

qualified check and a notice of allocation for

$720. The patrons pay taxes on the allocation and may redeem their equity investment

of $720 at some time in the future. The

Under Subchapter T, retained earnings allocated to patrons on the books of the association becomes borrower capital. Revolving

schedules may or may not be required,

depending on how much borrower capital

the association wants or needs to include in

its permanent capital calculation. However,

borrowers may expect that these allocations

will ultimately be paid out in true cooperative fashion, and association management

may therefore view the capital as something

that will eventually need to be replaced.

There are approximately equal numbers of

FCSIs that are tax-exempt, filing as C corporations, or filing as Subchapter T cooperatives. The 61 institutions filing under

Subchapter T—30 percent of all FCS associations—are spread across almost every district as shown in Figure 2.

Effects of Different Tax Structures

on Farm Credit System Institutions

and Their Patrons

FCSIs that are subject to taxation can choose

the tax filing status that best suits their longterm goals. This will have an effect not only

on taxes paid, but it can also effect the capital position and the interest rates the instituTable 2

Tax Treatment of Cooperative Business Structure (T) and General Business

Corporation Structure (C)

General Business

Cooperative Structure Corporation Structure

Cooperative Patron Corporation Stockholder

Gross Income $10,000 $10,000

Expenses 9,000 9,000

Taxable income 1,000 1,000

Corporate income tax10 350

Qualified allocation/

 income declared $1,000 $650

Cash dividend 280 650

Individual income tax2280 182

After-tax income 720 468

Total taxes paid $280 $532

1. Effective rate of 35% assumed. No allowance made for state income taxes.

2. Effective rate of 28% assumed. No allowance made for state income taxes.

23
FCA 1998

Mid-Year Report

cooperative retains and continues to utilize

the $720, if it so desires. A C corporation, on

the other hand, would pay tax on its $1,000

income. The comparison in Table 2 shows

how Subchapter T election minimizes overall taxes paid. In this example it was assumed

that the corporation had no retained earnings, a reflection of investor pressure on

management to maximize dividend distributions. In reality the total taxes paid will

vary from case to case depending on state

and Federal tax rates and earnings retention,

but the relative effects will remain the same.

In this example, the tax treatment afforded

the cooperative with single taxation at the

individual level results in less taxes paid than

by a corporation taxed at both the corporate

and individual levels. Total tax for the cooperative/patron structure is $280, and $720 can

be retained at either the cooperative or individual level, while total tax for the corporation/stockholder structure is $532, and $468

is retained at the individual level.

If the corporation elected to pay a smaller

dividend, the effects of double taxation would

have been reduced, with a corresponding

increase in capital retained at the corporate

level. However, even if the corporation did

not pay any dividends in the example cited,

the $350 it paid in taxes is more than the

$280 paid by the cooperative and its patron

combined. It is interesting to note that an

FCSI that declares no dividend, but retains

all its surplus and an FCSI that pays a cash

dividend of 35 percent may have similar cash

flows. Both have 65 percent of their surplus

remaining for whatever needs may arise.

Table 3 compares the tax consequences of

three organizational structures currently used

by banks or FCSIs. Dividends or patronage

paid is based on the amount of income historically distributed (or dividends paid) by

each. By projecting the tax consequences of

a commercial bank filing under Subchapter

S, Table 3 highlights the competitive situation of financial services firms filing under

each of these organizational structures.

In this example, a bank filing as a C corporation earns before-tax net income of $1,000

in a given year and pays corporate income

taxes of $350. That leaves after-tax net

income of $650. The $455 stockholder dividend used for banks under Chapter C and

Subchapter S represents the average bank

stockholder dividend paid in 1997, according to the FDIC3 . The Subchapter T corporation represents an FCSI that declares a

$1,000 patronage dividend but retains $600

for growth and expansion. Underlying

assumptions are generally consistent with the

previous example except that dividends distributed are consistent with current practices.

Table 3

Tax Treatment under Alternative Organizational Structures

C Corporation S Corporation T Cooperative

Taxable income $1,000 $1,000 $1,000

Corporate income taxes 350

Average dividend/

qualified patronage paid 455 455 400

Retained earnings 195 545 600

Individual income tax due 127 280 280

After-tax cash flow to owner 328 175 120

After-tax income to owner 523 720 720

Total taxes paid $ 477 $ 280 $ 280

1. Effective rate of 35% assumed. No allowance made for state income taxes.

3. In 1997, FDIC Call reports showed that 70 percent of after tax net

income of banks was paid out in stockholder dividends.

24
FCA 1998

Mid-Year Report

We also assume that taxable income is the

same as net income before taxes and that all

net income is allocated.

Given the broad assumptions made, it

appears that Subchapter S can produce significant tax savings for commercial banks

and the tax savings will be essentially the

same as those that FCSIs achieve using Subchapter T.

Organizational Options for Farm

Credit System Institutions

FCSIs have a variety of options when it comes

to choosing a tax strategy. In addition to

maximizing their tax advantages, other factors influence this choice, including management philosophy, capital position, market

share, and competition issues. The three

scenarios in Table 4 illustrate how using different tax structures can minimize the combined taxes paid by the FCSI and the shareholder. We assume that all income is paid to

the shareholders in order to maximize the

net tax savings to the ultimate beneficiary,

the farmer/borrower. In reality, how an

institution chooses to manage its earnings

will in part depend on the taxes it expects to

pay. FCSIs filing as C corporations may not

choose to distribute all their earnings to

shareholders, but rather may choose to retain

more capital or return the savings to their

customers in the form of lower pricing strategies. These types of decisions typically

involve more than the simple tax analysis

discussed here. However, this example is

narrowly constructed in order to analyze the

tax consequences of the different filing

options for FCSIs and to compare with the

Subchapter S case for commercial banks.

In order to analyze the tax consequences of

possible organizational structures available to

FCSIs, we look at three types of institutions

that have both long and short-term assets.

The first scenario illustrates an FCSI with

both long and short-term assets (such as an

ACA) filing as a C corporation. The second

shows a jointly managed institution (such as

a PCA/FLCA) where the short-term assets

are taxed as a C corporation and the institution does not pay taxes on its long-term

assets. The third shows an FCSI with both

long and short-term assets (such as an ACA)

filing as a Subchapter T cooperative.

Consistent with our earlier examples, we

assume a corporate tax rate of 35 percent

and a personal tax rate of 28 percent. For

the PCA/FLCA scenario, we assume the real

estate portion of the portfolio is 56 percent,

and income is allocated proportionately at

56 percent for the FLCA assets and 44 percent for the PCA assets4 . We assume that all

after tax earnings are paid out as dividends

to shareholders.

As shown in Table 4, total taxes paid by both

the FCSI and its owners are minimized in

the Subchapter T example (28 percent) compared to the PCA/FLCA example (39.4 percent) or the C corporation example (53.2

percent).

Alternatively, when an FCSI wants to retain

more capital to facilitate growth and implement long-term strategies, it can declare a

qualified patronage dividend, paying out a

cash dividend of at least 20 percent and a

written notice of allocation for the balance.

This would be the same as the example above,

with the exception that the FCSI would retain

the $720. The patron would get the $720 in

cash in a future year when the qualified

notice of allocation is redeemed.

Another option is for the FCSI to declare a

nonqualified patronage dividend. In this

scenario, the FCSI, not the patron, pays the

tax on the retained surplus. However, in subsequent years, when the institution pays out

the money represented by the nonqualified

notice to the patron, the institution files for

a refund of taxes previously paid on the surplus, and the patron pays taxes on the dividend received. Again, this is similar to the

example above, except that the income and 4. Based on actual System performance in jointly managed associations.

25
FCA 1998

Mid-Year Report

tax effect on the individual patron is delayed

for a period of years, until the nonqualified

notice is redeemed. In this latter strategy,

the undistributed retained earnings can be

counted as core capital under FCA regulations until the earnings are allocated and

distributed.

Effects of Filing Status on Financial

Condition

The choice of corporate form will normally

effect an institution’s behavior. For owners

of C corporations, there is an incentive to

keep patronage refunds low and either retain

after tax earnings to build capital, or to lower

interest rates charged borrowers, thereby lowering taxable income. In contrast, highpatronage dividend payouts are relatively

more advantageous in the management of T

associations’ earnings. Thus, one might

expect Subchapter T associations to have

lower levels of capital on average. However,

no significant differences were found in the

financial ratios for FCSIs when compared

based on their tax filing status as of March 31,

1998. On average, FCSIs had similar core

surplus, permanent capital, and total surplus

ratios, regardless of tax filing status, as shown

in Table 5. This may be due in large part to

regulatory capital requirements.

The tax benefits of filing under Subchapter

T seem considerable for those institutions

with both long- and short-term lending

portfolios that want to minimize their taxes.

Institutions converting to Subchapter T status can (and apparently do) retain some of

the tax savings as higher capital levels. The

institution owners reap some of the tax savings directly through patronage taxed at only

one level. FCSI owner-borrowers realize

lower effective loan rates as equity investments are revolved out to patrons.

Table 4

Tax Treatment of Alternative Organizational Structures Available to Farm

Credit System Institutions

Jointly Managed

PCA/FLCA

(C Corporation/ Subchapter T

C Corporation Non-Taxable) Cooperative

Income before taxes $ 1,000 $ 1,000 $ 1,000

Pro-rata share of

 income to PCA/FLCA 440/560

Corporate income taxes (35%) 350 154

Taxable net income to owners 650 286 1,000

Average dividend/

 qualified patronage paid 650 856 1,000

Personal taxes on dividends (28%) 182 240 280

After-tax cash flow to owner

 (dividends - personal taxes) 468 616 720

Total taxes paid $ 532 $ 394 $ 280

26
FCA 1998

Mid-Year Report

Other Pros and Cons

Many FCSIs believe Subchapter T filing provides them with a valuable tax management

tool, and they enjoy the obvious benefits of

single taxation. Because benefits are passed

on to patrons through patronage, this means

lower effective loan rates for borrowers.

Some FCSIs have been able to rebate almost

two-thirds of the annual interest due. As a

result, these FCSIs have been able to price

their loan rates at market rates and cite fewer

pricing complaints from competitors. By setting their revolving surplus cycle at greater

than 5 years they are able to claim a portion

of the surplus as core capital. They also

believe that the cooperative structure and

related patronage help build owner interest

and customer loyalty.

Many FCSIs file as C corporations and are

taxed at regular corporate income tax rates.

Dividends, if paid, are taxed again at the regular individual income tax rates. However,

many FCSIs filing as C corporations do not

pay patronage dividends. Because the maximum tax rates for corporate taxpayers and

individual taxpayers are similar, they see no

relative advantage to shifting the tax burden

from the FCSI to the patron. In fact, they

see a distinct disadvantage to paying patronage dividends. In their view, it creates the

expectation among patrons that allocated

equities will always be revolved out, regardless of the need at the cooperative level.

Hence, payouts detract from the value of the

surplus and an FCSI’s ability to expand and

grow. They believe that patronage dividends

should be paid only if capital is adequate and

can be sustained over time or can be viewed

as a rebate on interest payments by the borrower.

Implications of Tax Law Changes

Small, investor-owned banks with fewer than

75 shareholders have only recently been given

authority to reorganize as Subchapter S corporations. Commercial banks that elect to

convert will pass through all of the income

and expenses associated with their operations

to their stockholders, achieving one-level

taxation and a higher level of capital available to retain or reinvest.

The implications for FCSIs are significant. A

tax advantage available to all FCSIs but

claimed by only half will now be available to

many competing rural and community

banks. They may choose to pass on all, some,

or none of these tax benefits to their customers. If any of these benefits are passed

Table 5

Selected Financial Ratios by Tax Filing Status for Farm Credit System

Institutions

C Corporation Subchapter T Tax-Exempt

Core surplus 10.5% 11.5% 12.8%

Permanent capital 18.5% 18.5% 16.6%

Total surplus 14.5% 15.1% 14.2%

Allowance to loans 2.8% 2.8% 1.8%

27
FCA 1998

Mid-Year Report

on to customers, it will result in stiffer competition for agricultural loans for FCSIs, especially if they are unable to take advantage

of the Subchapter T benefits currently available to them.

Also on the horizon is legislation proposed

in July 1998 that would let a company qualify

for S corporation status if it has no more

than 150 shareholders. If enacted, this legislation would expand eligibility and, with

other proposed changes, make it easier for

small banks to convert to S corporations.

This added tax relief will make them more

competitive with FCSIs. Currently 1,009, approximately 25 percent, of small commercial

banks (those with assets less than $150 million) have converted to S corporations. That

leaves another 3,000 potential candidates for

conversion.5

In Summary

This article demonstrates that

- The Subchapter T can minimize taxes

and is used by half of the taxable FCSIs.

- Commercial banks have begun to convert to Subchapter S Corporations allowing those institutions to enjoy tax benefits similar to Subchapter T.

- Other factors such as capital position,

dividend distribution, and management

philosophy will need to be considered in

selecting the most advantageous organizational structure.

5. Conversion is gaining in popularity, as is evidenced by inclusion

of this topic in the American Bankers Association’s fall 1998

annual meeting agenda.

28
FCA 1998

Mid-Year Report

Risks Associated with the Millennial

Date Change

Thomas Glenn and Robert Andros

Introduction

The year 2000 problem, or the ability of some

automated systems to comprehend dates

beyond 1999, poses a serious challenge for

the financial services sector, including Farm

Credit System institutions. Overall, the Federal Reserve has warned that the Y2K problem may bring about an economic slowdown

(or worse, according to some analysts) as

firms are required to divert resources to “nonproductive endeavors.” On an operational

level, each FCSI faces a series of risks associated with the millennial date change: in its

computer systems; embedded systems; supplier, client, and servicer interfaces; customer

risks and related ripple effects; infrastructure,

and government services.

The Farm Credit Administration has provided timely and comprehensive guidance

to FCSIs at both the general and individual

institution levels. All FCSIs had made

progress toward Y2K remediation during the

second quarter of 1998. Nevertheless, failure

to adequately address each area of risk successfully can increase the potential for legal

liability. If Congress does address the issue

of a Y2K liability cap for businesses, it will

also need to establish what criteria need to

be met to qualify for the limitation. These

criteria may include that firms demonstrate

they employed “best management practices”

or that they provide independent certification that all systems were fixed using a wellreasoned and comprehensive methodology.

Operational Risks

The principal areas of operational risk that

each institution or organization faces are:

• Computer systems. Almost all databases

within financial institutions are computerized. Computer hardware, firmware, and

software (application programs) all have

the potential to malfunction or refuse to

function altogether on January 1, 2000.

Moreover, different computer systems,

some of which may use different programming languages, often coexist within the

same institution, and these systems’ interfaces may require compatible, if not consistent remediation methods. Functions

served by these computer systems include

calculating interest, dividends, maturities,

and amortization schedules, electronic data

interchange, and automated clearinghouse

activities.

• Embedded systems. These are individual

or small assemblies of microprocessors

used to control, monitor, or assist the

operation of equipment or machinery.

They do not necessarily involve a computer and are therefore not obvious to the

user. Embedded systems are generally

capable of performing only a predetermined single function or set of functions.

Some have a timing function while others

do not. Frequently, the only way to determine these systems’ Y2K compliance is by

studying their documentation or contacting the vendor. Common examples of

equipment with date-sensitive embedded

systems include telephone systems, fax machines, vaults, security and alarm systems,

microwave ovens, videocassette recorders,

and automatic teller machines (ATMs).

While most companies have recognized

the problem and begun assessing the Y2K

compliance of their computer systems,

experts have expressed concern that embedded systems have not been given the

same level of scrutiny as computer systems.

• Interfaces. Like other financial institutions,

many FCSIs are dependent on third-party

servicers for some or all of their computer

processing needs. Most financial services

institutions are dependent on suppliers,

customers, and vendors for data input and

processing of their own data. Examples

include a customer who banks by computer, a correspondent bank that bills

directly through a client bank’s computer

E ach Farm Credit System institution faces

certain risks associated with the millennial

date change. Because of their pervasive

nature, these risks may not be self-evident.

This article describes these vulnerabilities,

explains how they may affect an FCSI, and

summarizes FCA guidance issued on the

subject. It also describes what actions an

FCSI can take to mitigate against these risks,

especially that of legal liability, and their

possible consequences on an institution.

29
FCA 1998

Mid-Year Report

system, and the Federal Reserve’s Fedwire

system, which handles payment, clearing,

and settlement functions for member

banks via computer. Many firms have already experienced Y2K problems in their

financial services. For example, Produce

Palace, a gourmet food outlet in Michigan, found that credit cards listing 2000 as

their expiration date caused the store’s

computer system, installed only two years

ago, to crash more than a hundred times,

often for several hours at a time. This cost

the store lost revenues as it attempted to

process its transactions manually. In the

end, Produce Palace sued its credit card

scanner supplier for damages. Several

commercial banks have experienced similar problems with their ATMs. Even

though all of a bank’s computer systems

may be fixed to accept the millennial date

change, their interfaces pose a separate

risk and require separate testing.

• Customers. A financial institution is

especially dependent on the success of its

borrowers and the composition of its balance between assets on hand and customer

needs. Financial regulators are becoming

increasingly concerned over the Y2K compliance of bank customers, especially small

businesses, and the possible effects of their

Y2K noncompliance. Many large businesses are also openly concerned about the

Y2K compliance of their suppliers, particularly since “just-in-time” inventory scheduling is a common business practice today. Although this practice reduces costs,

it makes no allowance for business outages, the results of which can prove catastrophic. Even the potential ripple effect

on a financial institution of a large customer failing to obtain timely supplies

from a small business that is not Y2K compliant is significant. A business risk faced

by a bank’s business customers, as well as

the bank itself, is a possible loss of consumer confidence and the resultant loss of

customers that can mean failure for a firm.

In addition, foreign countries are reportedly way behind in their Y2K remedial

efforts. Because agricultural producers are

largely dependent on foreign export markets, this may be another potential ripple

that requires monitoring. Finally, a number of FCSIs that needed to improve their

Y2K efforts have not adequately assessed

the risk of the millennial date change on

their customers’ operations. Some financial institutions are therefore concerned

about a possible liquidity imbalance on

January 1, 2000, leading to a potential liquidity crunch.

• Infrastructure. Financial institutions have

an internal and an external infrastructure.

Internal infrastructure components include elevator, heating, air conditioning,

telephone, and security systems. External

infrastructure components include transportation networks, telecommunication

systems, and local utilities such as electric

power, gas, water, and sewer facilities. Each

of these components will face its own specific set of Y2K compliance risks when the

millennial date changes. Many of these

components rely heavily on embedded

systems.

• Government services. All financial institutions rely on government services. These

range from regulatory approvals and check

clearing and settlement systems to agencies that employ electronic fund transfers.

Any Y2K noncompliance by these government agencies (whether at the Federal,

state, or local level) in their critical systems could adversely affect a financial

institution’s performance.

Surveys show that most financial institutions

have found it necessary to hire outside technical support to assist in their Y2K

remediation efforts. These outside resources

are limited, however, and some prominent

computer consulting firms have announced

that they will not take on additional Y2K cli30
FCA 1998

Mid-Year Report

tion costs and damages will exceed $1 trillion in the United States alone. What’s more,

firms may be vulnerable to court suits and

related damages not just for their own actions

but for those of their business partners as

well. Potential liability for FCSIs may come

from a number of different sources, including investors, customers, business partners,

and other third parties. These parties rely

on the integrity of FCSI data, the stability of

System operations, software vendors, and

maintenance providers, flawless FCSI merger

and acquisition activities, and more. Liability troubles that may surface include:

• Director and Officer Liability. Bank officers are subject to the stringent criteria of

ethics and fiduciary duty. Bank executives

and directors may find themselves facing

severe personal liabilities unless their Y2K

problems are safely contained within their

institutions’ operations. To avoid personal

liability, directors and officers are required

to meet applicable legal standards of care

in taking action to solve Y2K problems in

their institutions. While FCSIs may have

director and officer liability insurance,

some insurance companies have openly

questioned whether their policies will

cover known management problems such

as Y2K noncompliance.

• Disclosure Issues. The Securities and

Exchange Commission (SEC) Staff Legal

Bulletin Number 5 requires certain Y2K

disclosures by publicly traded firms. To

date, the legal bulletin has not induced the

types of disclosure the SEC and Congress

had anticipated. As of June 30, 1998, only

85 of the 500 largest publicly traded U.S.

companies had disclosed their estimated

Y2K costs. Legislation (S.1518, the Computer Remediation and Shareholder Protection Act, or CRASH) has been introduced that would mandate full Y2K disclosure by publicly traded firms. While

this does not affect Farm Credit System

ents because of the potential legal liability to

which their firms might be exposed. To date,

Coopers and Lybrand has been the only Big

Six accounting firm engaged in Y2K

remediation work, and it is reportedly

reviewing its position on this issue subsequent to its merger with Price Waterhouse.

Hence, reliable resources will be a scarce and

costly commodity for firms that needlessly

delay launching their remediation activities.

A significant decision facing all financial

regulators is if and when to require a merger

or takeover of financial institutions that are

not Y2K compliant. Unfortunately, authorities and approaches for dealing with troubled

institutions vary from one regulator to

another. On the international front, the Bank

of England has announced it would close

down banks found to be Y2K noncompliant.

U.S. regulators, on the other hand, have been

uncomfortable with setting arbitrary “drop

dead” dates, preferring instead to deal with

problem institutions on a case-by-case basis.

On the other side of the fence, the problem

facing the absorbing institution is whether it

has enough time to assimilate a

noncompliant bank’s customers into its own

system to avoid potential legal liability for

itself. Hence, regulators have to consider

these needs when deciding what constitutes

timely supervisory action. The bottom line

for each regulated financial services institution is that remediation efforts cannot be

delayed. Both Congressional staff and GAO

are encouraging regulators to take a proactive

approach by anticipating any need for mergers prior to January 1, 2000, rather than

waiting for financial institutions to fail their

customers before taking action.

Liability Risks

Perhaps the thorniest Y2K issue has yet to be

addressed, much less resolved. Both witnesses in congressional hearings and Lloyd’s

of London have estimated that Y2K litiga31
FCA 1998

Mid-Year Report

millennial date change. Bankruptcies may

easily occur among small, medium, or

marginally financed companies if the Y2K

problem disrupts power, shipping, financial services, export markets, or telecommunications long enough to harm cash

flow. Bankruptcies can also threaten the

safety and soundness of financial institutions, which will need to determine how

long they can support customers’ cash flow

problems before requiring settlement and

risking customer goodwill. Some financial institutions, including FCSIs, are already reviewing the Y2K compliance programs and contingency plans of their significant customers.

• Contracts, Advertising, and Customer

Agreements. Financial institutions’ accurate and continuous operations are expected by customers and business partners alike. Some may even seek written

confirmation and verification of timely

delivery of various goods and services in

anticipation of Y2K problems and to protect their own business positions. Advertisements, contracts, and written agreements as well as consumer protection laws

may expose FCSIs to liability. Moreover,

false claims by vendors of Y2K remediation

services may expose a financial or other

institution to additional risk. Because the

software industry is not regulated, skilled

resources are in scarce supply, and “proof

of claims” is a rarity among software tool

and service vendors, false claims may introduce another potential liability to unsuspecting firms. The GAO has already

noted a number of false claims of Y2K

compliance among Government vendors,

and the General Services Administration

(GSA) has been unable to attest to the Y2K

compliance of goods and services available through the GSA supply schedule.

institutions, it will set a standard of performance against which they may be

judged. FCSIs have also received guidance

on disclosure of Y2K costs from FCA’s

Chief Examiner. The Federal Financial Institutions Examination Council (FFIEC)

has recently cautioned that ”A financial institution may reduce its risks of litigation

if it discloses to beneficiaries information

addressing the Year 2000 date change.”

Omissions, inaccuracies, or misleading

statements regarding an institution’s Y2K

deficiencies may be cause for legal action

by investors or stockholders under Federal and state securities laws. Public auditors are concerned that if they fail to raise

the issue they may make themselves legally culpable. Due diligence investigations

are generally required before an investment

is made. Investors are now being made

aware of their fiduciary responsibility to

check on the Y2K compliance of firms

soliciting funding. These representations,

or lack thereof, could increase the cost of

funds or expose institutions making them

to potential liability.

• Client Risk. The financial performance of

FCSI clients may expose System institutions to some liability. Many of the

System’s clients are not subject to the SEC

disclosure rules, so the SEC is not a source

of reliable information regarding clients.

CRASH legislation is not likely to pass

soon enough to provide FCSIs reliable and

timely information on key suppliers and

business partners. A number of firms have

resorted to sending letters requesting suppliers’ and vendors’ assurances that they

are capable of meeting supply schedules

and are Y2K compliant. Responses to these

inquiries have been intermittent. Still other

firms, such as General Motors and Texaco,

have announced their intentions to make

on-site visits to key suppliers. Bankruptcies are a potential threat and among the

most troubling problems presented by the

32
FCA 1998

Mid-Year Report

• Documentation. Even if all necessary

plans and steps are undertaken to

remediate or otherwise remove Y2K deficiencies, a firm and its officers and directors may ultimately need to prove their

actions in court. Failure to develop and

maintain documentation of an FCSI’s efforts could expose it to needless liability,

as such documentation may be necessary

for legal defense, insurance claims, and

indemnification. Every System institution

should review all of its insurance policies,

contracts, and product documentation,

including warranties, to see who bears the

costs of fixing Y2K problems and under

what conditions. In licenses and agreements, Y2K compliance should be expressly and explicitly addressed. An inventory and review of licenses and agreements may identify vendors and software

manufacturers that have a legal responsibility to help solve the problem or contribute to the cost of correcting it. A review of company insurance policies may

determine whether the institution is covered for remediation costs, liability protection for directors and officers, casualty

and business loss, fiduciary activity, and

accounts receivable or other valuable

record loss. Even the ability to expense or

capitalize remediation costs for tax purposes may hinge on accurate and adequate

documentation.

• Third Party Risks. Aggrieved customers

and business partners may sue not only

Y2K deficient firms but their key business

partners (including auditors and creditors)

as well. This could expose FCSIs and other

financial services firms to liability beyond

their immediate control or sphere of

influence. In addition, FCSIs offering

automated farm management services that

rely on software vendors and maintenance

providers may be exposed to legal liability

if the computer products they use are not

Y2K compliant, interfaces with customers

do not function as expected, or

remediation efforts do not prove adequate

or compatible with those of suppliers, vendors, customers, and others.

• Other Risks. These include a range of

concerns, such as Merger and Acquisition

(M&A) and copyright issues associated

with Y2K remediation. If a company is

engaged in planning an M&A transaction,

due diligence requires expert assistance to

determine the nature, extent, and potential costs of Y2K problems the company

may inherit. Like other regulators, FCA

reviews corporate applications to ensure

that all conditions concerning the safety

and soundness of the FCSI, including Y2K

compliance, are met. This is not only a

concern for FCSI mergers but for the

institution’s customers as well. Another

area of concern for firms, as mentioned

above, is whether they have the legal right

to change copyrighted code to make it Y2K

compliant without the software

manufacturer’s consent. In some cases the

manufacturer may have gone out of business, merged, or no longer produces the

software in question. In other instances, it

may not want to grant a copyright exemption to users.

While Congress and the White House have

discussed limiting the liability exposure of

firms that fall victim to various Y2K deficiencies, they have also expressed reluctance

to legislate a safe harbor, thereby creating a

moral hazard. On July 14, 1998, President

Clinton announced his intention to propose

“Good Samaritan” legislation that would

immunize businesses from lawsuits if they

share information about their common Y2K

problems. However, the Chairman of the

President’s Y2K Conversion Council, has

described this legislation as “a narrow, carefully defined bill.” To date two narrowlydefined liability limitation bills have been

introduced. The Administration’s “Good

Samaritan Bill” and a bill introduced in the

House limiting punitive damages for com33
FCA 1998

Mid-Year Report

puter and software companies. To date no

comprehensive Y2K legal liability legislation

has been introduced. Congressional leaders

have indicated that any liability limitation

legislation will need to incorporate some performance criteria, such as certification that a

firm used best management practices, in

order for that firm to qualify for a liability

cap.

FCA Guidance and System

Performance

The Farm Credit Administration has adopted

the FFIEC’s Y2K rating system for System

institutions. It also has provided FFIEC

guidance to FCSIs in a timely manner and

augmented that guidance where appropriate.

The FFIEC, following the GAO and Office

of Management and Budget (OMB) guidelines for Federal agencies, has outlined five

management phases (with target completion

dates) necessary for an organization to complete a successful Y2K system conversion

program. They are:

Awareness – to be completed by December

1996.

Assessment – to be completed by June 1997.

Renovation – to be completed by December

1998.

Validation – to be completed by January

1999.

Implementation – to be completed by

November 1999.

The FCA Chairman’s May 14, 1998 testimony

before the Senate Agriculture Committee

highlighted both the FCA’s and the System’s

progress in achieving Y2K compliance.

Guidance issued by the FCA’s Office of

Examination (see list at right) as well as the

June 30 survey results indicate that both the

FCA and the System are well under way in

pursuing a timely resolution of the problems

posed by the Y2K technology problem.

Year 2000 Guidance Issued to

FCSIs

Year 2000 Awareness. This informational

memorandum provides guidance on the

critical issues FCSIs need to address to resolve Y2K problems and avoid major service

disruptions. It highlights the five phases of

remediation and establishes milestone dates

for their completion. Issued June 6, 1997.

Disclosure of Year 2000 Costs. This informational memorandum provides guidance

on the disclosure of costs associated with Y2K

remediation efforts. Issued November 14,

1997.

Year 2000 Business Risk. This informational

memorandum outlines director and senior

management responsibilities for addressing

business risks. It outlines and describes the

types of Y2K-related business risks to which

FCSIs may be exposed. Issued January 8,

1998.

Expectations for Testing of Mission-Critical

Systems. This informational memorandum

provides additional guidance and details on

relevant milestone dates for testing missioncritical systems. Issued March 17, 1998.

Service Provider and Software Vendor Year

2000 Readiness. This informational memorandum provides guidance on and establishes responsibility for overseeing the Y2K

compliance of service providers and software

vendors with regard to mission-critical systems. Issued April 13, 1998.

Year 2000 Impact on Customers of Farm

Credit System Institutions. This informational memorandum addresses the risks

posed by customer vulnerabilities to Y2K

problems. It provides guidance for identifying and documenting risks posed by material FCSI customers. Issued April 23, 1998.

34
FCA 1998

Mid-Year Report

Testing For Year 2000 Readiness. This informational memorandum provides guidance

on the types and nature of tests required to

ensure that Y2K remediation efforts are successful. Issued May 20, 1998.

Contingency Planning for Business Continuity. This informational memorandum

describes the types of contingencies, both internal and external to the institution, that

plans must address to ensure business continuity through the millennial date change. It

also establishes relevant milestone dates.

Issued June 30, 1998.

As of June 30, 1998, each FCA field office/

division had completed an updated Y2K assessment of each FCSI regarding the five

management phases. Using the survey results, each FCSI was assigned a rating of “Satisfactory,” “Needs Improvement,” or “Unsatisfactory.” Because each of the management

phases has a time frame within which specific work is to be accomplished, a satisfactory rating for one quarter does not imply a

satisfactory rating in subsequent quarters; it

simply means that the FCSI is currently on

track to complete its remediation work by

the deadline. This dilemma was highlighted

in February of this year when OMB took the

U.S. Department of Labor off the list of Federal agencies making adequate progress and

added it to the list of agencies making insufficient progress. Therefore, although the

Farm Credit System is making progress, it

must continue on a fast track to ensure timely

and successful Y2K remediation.

Overall, the survey results from the second

quarter of 1998 show marked improvement

by FCSIs since the previous quarter. More

importantly, each FCSI showed improvement

during the most recent quarter. FCSIs rated

“Unsatisfactory” declined from 74 in the first

quarter to only 2 in the second quarter, or

less than 1 percent. Institutions rated “Satisfactory” increased from 71 in the first quarter to 133 in the second quarter. Among the

81 FCSIs that were rated “Needs Improvement,” a common weakness was the lack of

adequate effort to identify borrowers whose

operations may be adversely impacted by the

millennial date change. This issue was highlighted and specific guidance provided in an

April 29, 1998 letter from the Chief Examiner to each FCSI. Those rated “Needs Improvement” also demonstrated lingering

project management weaknesses, the absence

of an effective Y2K audit program, or a late

start that means they are still “playing catch

up” on the project. Each of these institutions

received specialized and specific guidance

from FCA examiners on how to improve

their Y2K compliance.

Because the Farm Credit System is classified

as a single Government-sponsored enterprise

with jointly managed funding, there is interdependence within the System. FCA therefore undertook to determine which FCSIs

were “high-profile” institutions that required

special monitoring. High-profile institutions

are the primary data centers for the Farm

Credit System, and they develop, maintain,

and control most of the Systems’ missioncritical systems. Low-profile institutions generally contracted with a high-profile counterpart to maintain their mission-critical systems. None of the 20 high-profile institutions is rated “Unsatisfactory,” and 80 percent are rated “Satisfactory.” This information is important for System investors. Recently, legislation was introduced that emphasizes investors’ fiduciary duties and underscores their responsibility to evaluate the

Y2K risks of institutions in which they invest.

Owing to the nature of the risks described

above, FCA’s most recent focus has been on

contingency planning. Under guidance issued by the Chief Examiner on June 30, 1998,

each FCSI is expected to have a business

contingency plan in place by the end of this

year. These plans need to address both the

possibility of internal system failure and the

possibility of external system failure from

service providers, software vendors, other

35
FCA 1998

Mid-Year Report

institutions, customers, business partners,

utilities, etc. These Y2K plans are to be designed to ensure that mission-critical systems

can continue to function despite potential

Y2K system failures.

Conclusion

It is impossible for any financial services firm

to insulate itself entirely from the repercussions of the millennial date change. At a

minimum, adverse economic effects are likely

to be felt within the Farm Credit System and

among its customers. There will be a transfer of business between Y2K compliant and

noncompliant firms. The financial services

sector will be exposed to the business risks

of its customers, some of whom may either

fail to perform successfully after the

millennial date change or simply lose the

confidence of their consumers who seek

other business partners and vendors.

The financial services sector is highly dependent on date-dependent automated services.

While FCSIs seldom face the complex problems associated with embedded systems, they

are highly dependent on interfaces with suppliers, vendors, servicers, and others. For

most firms, testing these interfaces is not

likely to be possible until the fourth quarter

of 1999, leaving little time for last-minute corrections. Contingency planning for FCSIs

will become increasingly important.

As an arm’s-length regulator, FCA is in a

unique position to provide both value-added

and important support and assistance to

FCSIs in their quest for Y2K compliance.

Diligent adherence to the Agency’s guidance

and direction will assist FCSIs seeking to

minimize or otherwise limit their legal

liability. Many challenges and obstacles lie

ahead for financial service institutions and

their respective regulators. The January 1,

2000 deadline is an unyielding time constraint. For institutions unable to meet this

deadline and even for some that do there lies

the prospect of court suits and other legal

liability posed by various Y2K deficiencies.

While there has been discussion concerning

legislating a liability caps for firms that follow best management practices to remediate

their Y2K problems, there is also opposition

to legislating a liability cap. If no legislation

is passed, it will fall to each FCSI to develop

sufficient documentation of its remediation

efforts to defend itself against potential lawsuits. Whether in response to legislative criteria for liability limitations or in response to

a court suit, FCSIs may benefit from independent certification that their remediation

plans were consistent with regulatory guidance, comprehensive and thorough, and carried out in their entirety. System institutions

may mitigate their liability exposure if they

follow FCA’s Y2K guidance and document

that they did so.

36
FCA 1998

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Introduction

Recent prosperity in the U.S. farm sector has

been driven primarily by booming exports

to Asian markets, particularly to those emerging in Southeast Asia. In 1997, Farm Sector

Economics was forecasting continued prosperity for U.S. agriculture, and presented that

optimistic forecast in a series of regional

briefings for the Farm Credit System. The

scenario was based on the assumption of

continued strong economic growth in the

Asian markets.

Now that those markets have collapsed, the

forecast has changed from optimistic to pessimistic. Farm commodity prices continue

to fall. In mid-August, the USDA was predicting that farm income would decline by

$7.4 billion in 1998 from the 1997 figure of

$49.9 billion. From the 1996 level net farm

income is forecast to decline by $11 billion,

representing a two-year income loss of 20

percent. Unless new or revived export markets can be found, farm income now looks

to remain weak for at least two to three more

years.

As a result of this expected weakness, the

Farm Credit Administration requested Farm

Sector Economics, Inc. to provide the Agency

with an assessment of the degree of risk associated with the Asian events and to provide a model to show the effects of these risks

under different key economic variables in individual Farm Credit Districts. FCA was provided with two updated forecasts: the 1998

Baseline Scenario and a Continued Asian

Depression Scenario.2

The 1998 Baseline Scenario forecast assumes

that the Asian economic problems, bad as

they are, will be resolved in 1999. We assume the region will resume positive economic growth, although at a rate only about

half as fast as before.

However, the Asian economic depression

could be deeper, more widespread, and longer

than assumed in the Baseline. To better

understand this risk, the Continued Asian

Depression scenario was developed.

Overview of Results

The model’s 1998 Baseline Scenario is now

forecasting the first decline in U.S. farm real

estate values sector-wide and in farm sector

equity since recovery began from the depressed 1980s. The latest forecast (as of August 1998) shows extremely weak real estate

markets through the year 2002. As a result,

the farm debt market is also forecast to be

weak, with increasing financial stress occurring in the form of increased bankruptcies,

deteriorating balance sheets, and, for lenders, more problem loans and loan losses.

Although not predicted to be remotely as

severe as the stress of the 1980s, the decline

marks the first serious long-run challenge to

farm financial performance since that time.

A prolonged depression in the economies of

Southeast Asia would have a profoundly

negative impact on the U.S. farm sector and

on agriculture in each of the seven Farm

Credit Districts. Using the model under the

Continued Asian Depression scenario, U.S.

net farm income would be reduced by an

average of $2 billion per year, or 5 percent

below the already-reduced Baseline forecast.

The model also shows the effects of each

scenario on farm income, farm real estate

values, and farm debt for the states in each

of the Farm Credit System’s seven districts.

As an example, the model shows that the consequences of the Continued Asian Depression scenario would be more severe in the

AgriBank Farm Credit District, where farmers would receive an annual average of $529

million less (4.1 percent) in annual net farm

income over the next five years. Most hardhit on a percentage basis would be the

Effects of a Prolonged Economic

Depression in Southeast Asia on the

U.S. Farm Economy

Dr. Paul T. Prentice1

Farm Sector Economics, Inc.

1. The FCA has commissioned Dr. Prentice’s firm, Farm Sector Economics, Inc., to provide an outlook for the U.S. agricultural

economy and for the districts of the FCS. While the Agency does

not necessarily endorse this specific outlook, we believe the information presented will be useful in helping System institutions

and other readers understand the effects of the recent events in

Asia and make plans for their portfolios.

2. Farm Sector Economics, Inc., calls the model it uses for these forecasts the AGSEC Model

This article shows how recent events in Asia

have significantly altered the forecast for farm

income and farm real estate values over the

next five years. Forecasted results are provided

on a regional basis so that the effects on each

Farm Credit district can be revealed. In addition, the article reviews price forecasts for each

major farm commodity and shows how these

commodity prices might be further reduced if

conditions in Asia continue to be depressed.

37
FCA 1998

Mid-Year Report

Wichita District, where net farm income

would be reduced an average of $173 million, or 6.1 percent, annually. The effect

would be least severe in the northeastern

states served by CoBank, with an annual

income loss of $10 million or 0.7 percent.

The model does not account for the effect

on fruits, vegetables, and specialty crops,

thereby understating the loss in certain regions. In reality, the effect on these districts

would be much more severe, as Asia is a

major export market for these commodities.

In addition, the model does not account for

the decline in foreign exchange rates versus

the dollar, which could also make conditions

worse than forecast.

Fortunately, today’s external inflation and

interest rate environment is much more favorable than in the mid-1980s when the farm

financial collapse occurred. What’s more,

farmers and their lenders are for the most

part better positioned, both in their financial strength and in their more conservative

lending practices, to weather the storm.

Unless the Continued Asian Depression Scenario gets worse, any extreme stress will be

localized and short-lived compared with that

of the 1980s.

The Importance of the Asian

Market for Agricultural Exports

The Asian markets averaged 48 percent of

the value of all U.S. farm exports over the

1995 to 1997. (See Figures 1 and 2.) Emerging countries in the region had been averaging 6 to 8 percent real economic growth

during the 1990s. (See Figure 3.) This astounding economic growth led to a rapid

upgrading of diets that, when combined with

a large and growing population base, created a boom in demand for U.S. farm exports. This phenomenon, in turn, created

new prosperity for U.S. farmers and their

lenders.

Beginning in the summer of 1997 and continuing today, several Asian countries have

experienced a collapse in their currencies

that has resulted in economic depression.

The situation is worst in Indonesia, Malaysia, the Philippines, Singapore, Thailand, and

Vietnam, but is also severe in Hong Kong,

South Korea, and Taiwan. (For convenience,

we define this entire set of countries as

“Southeast Asia.”) Even more disturbing, the

effect has spread to the most developed economic powerhouse in the region—Japan—

which has fallen into recession in 1998 with

weak prospects for recovery. The InternaFigure 1

Major Commodities: Percent of U.S. Production Exported

Average of 1995-1997

Source: USDA data. Percent

38
FCA 1998

Mid-Year Report

tional Monetary Fund (IMF) bailouts for the

emerging economies may be too little, too

late. Moreover, the regional problems in

Southeast Asia could spread to the remaining bright spot for long-term farm export

expansion — China. Hong Kong is already

officially in recession. The collapse of the

Russian currency and stock markets in late

August will only make matters worse. We

expect that the Asian recovery will be slow

and varied, unlike the relatively rapid Mexican recovery in 1995.

Baseline Scenario Assumptions

The Baseline Scenario used in this study

made the following assumptions:

The most important change in the Farm

Sector Economics macroeconomic forecast

since the 1997 update is the collapse of the

Southeast Asian economies last fall. This will

lead to a slowing of U.S. economic growth

and rising unemployment, which will take

pressure off what would otherwise be rising

inflation and interest rates.

Figure 3

S.E. Asian Annual GDP Growth: Three Scenarios GDP Growth (%)

Figure 2

U.S. Agricultural Production: Percent Exported by World Region

Average of 1995-1997

Source: USDA Data Percent

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FCA 1998

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• The 1998 Baseline forecast assumes that

the Asian economic problems, bad as

they are, will be resolved in 1999. We

assume the region will resume positive

economic growth after 1999, although

at a rate only about half as fast as before

(see Figure 3). Currency values will

gradually strengthen back to pre-collapse levels over the five-year forecast

horizon—1998 to 2002.

• The slow and uncertain Asian recovery

will be unlike the relatively rapid one in

Mexico. Japan, the most powerful

economy in Asia, has already slipped

from sluggish growth in 1997 to outright recession in 1998, and prospects

for recovery are weak at best. Hong

Kong has also officially slipped into recession.

• The weakening of the U.S. and world

economies will drive down domestic

demand for food and fiber. Low inflation will prevent general cost-push inflation pressure on the U.S. farm sector,

and stable-to-declining interest rates will

also prevent a sharp rise in the debtservice burden.

• U.S. and global supplies of major farm

commodities will grow consistent with

historical trends.

China remains a wild card in the outlook for

farm exports. With a population base of 1.2

billion (growing at 1.2 percent annually) and

with sustained real per capita economic

growth of 6 to 8 percent, the potential for

increased food demand is indeed huge — in

the range of 4 to 5 percent annual real growth.

We expect China’s domestic food production to lag behind growth in demand and

cause China to keep importing vast amounts

from the world market.

Should the Asian economic flu spread to

China, however, the nation would be forced

into a round of competitive currency devaluations. China’s economic growth would slow

dramatically and the U.S. would lose another

strong growth market for farm exports. This

is an important downside risk to the forecast.

With high crop production expected again

in 1998, stocks will continue the rebuilding

begun in 1997, which combined with weak

global demand will put more downward

pressure on prices. Due to the high percentage exported, wheat is the commodity most

at risk of facing chronic surpluses and low

prices. A glut of hogs has prevented cattle

prices from gaining as much as expected

during this rebuilding phase of the cattle

cycle.

Continued Asia Depression

Scenario Assumptions

There is a downside risk that the Asian economic depression will be deeper, more widespread, and longer than assumed in the

Baseline Scenario. In the Continued Asian

Depression Scenario, independent variables

except for lower economic growth in Southeast Asia were held at the levels of the Baseline

Scenario. The result is a forecast with “all

other things being equal.” We make the following assumptions about economic conditions in Asia:

The Continued Asian Depression Scenario

would reduce annual Gross Domestic Product (GDP) growth in that region by 5 full

percentage points below the 1998 Baseline

Scenario (which itself was already well below the assumptions in the 1997 Baseline).

The hardest-hit economies of Southeast Asia

will remain at depressed levels of economic

activity, experiencing –10 percent growth in

real GDP in 1998, –5 percent in 1999, and an

average of -2 percent from 2000 to 2002.

• Japan enters recession in 1998, then resumes a sluggish growth path in 1999, averaging only 2 percent annual growth in

real GDP.

40
FCA 1998

Mid-Year Report

• Economic growth in China slows to 6 percent in 1998 and averages only 3 percent

from 1999 to 2002.

• Asian currencies hold at current levels

against the U.S. dollar from 1999 to 2002.

Declining Rates of Foreign

Exchange

The model does not account for the additional negative effect of the collapsing currencies in Southeast Asia. Thus, the actual

impact on export demand will be more severe than in either of the scenarios depicted

here, as the collapse of currencies in Southeast Asian countries has been nothing short

of spectacular. Between December 1996 and

December 1997 the currency of Indonesia

was down 51.6 percent against the U.S. dollar, doubling the price of U.S. farm imports

into Indonesia. The currency situation was

nearly as bad elsewhere against the U.S. dollar: Korea was down 43.5 percent; Thailand

43.6 percent; Malaysia 33.0 percent; the Philippines 29.3 percent; Taiwan 15.3 percent, and

Singapore was down 15 percent. In spite of

the best efforts of the IMF, these currencies

continued to depreciate during the first half

of 1998.

The U.S. dollar also has risen appreciably

against the currencies of our major competitors among exporting nations. Over the past

year (July 1997 to July 1998), the U.S. dollar

is up 20 percent against Australia and 8 percent against Canada, the United States’ two

most important competitors in the world

wheat market. Similarly, the dollar is up 37

percent against South Africa, a major competitor in the world corn market; 19 percent

against India, a major competitor in the world

cotton market, and 11 percent against Brazil,

a major competitor in the world soybean

market.

A movement in foreign exchange rates is

equivalent to a change in domestic prices.

For example, if the value of the dollar rises

50 percent against a foreign currency, the

price of U.S. farm products measured in units

of that currency rises 50 percent, which depresses the quantity demanded even if U.S.

domestic prices remain constant. Empirical

research shows that farm exports are less

sensitive to changes in exchange rates than

are general merchandise exports, but they do

react, and with about the same two- to threeyear time lag. This suggests that the current

levels of exchange rates will depress U.S. farm

exports below what they would otherwise

have been for the next two to three years,

considering what already has happened, even

if foreign currencies recover some of their

previous value against the U.S. dollar.

Among exports of bulk agricultural commodities, soybeans are the most sensitive to

changes in exchange rates and wheat is the

least sensitive. Economic theory predicts that

the closer a market is to free competition,

the more responsive demand will be to

changes in prices and exchange rates. International trade in soybeans is much closer to

the free market model, while the wheat trade

is highly subsidized and regulated by governments.

In addition to the foreign exchange rate effect, a spillover of the Asian economic crisis

may reduce world GDP by perhaps 0.5 to 1

percent from what it otherwise would have

been. We did not simulate this effect; the

results reported here would likely be much

worse if the effects of both currency devaluations and diminished world GDP growth

were considered.

Finally, research shows that on average farm

real estate assets take six years to fully adjust

to changes in capitalized farm income.

Sometimes it has taken longer, sometimes

shorter. In this model, we forced the adjustment to occur over a three-year period for

the purposes of simulating a worst-case scenario for land values.

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FCA 1998

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Forecast Results Under the Two

Alternative Scenarios

Economic conditions in the U.S. farm sector

in 1998 are considerably weaker than in 1997,

when net farm income fell to $49.9 billion

from $53.5 billion in 1996. Net farm income

is expected to fall again to $42.5 billion in

1998—a 20 percent decline from the 1996

peak. Under the Baseline Scenario, 1999 net

farm income is forecast to rise a bit to $45.6

billion, but will remain below $50 billion

through the year 2002 (see Figure 4). Over

the next five years (1998-2002) net farm income will average about $1 billion less than

over the last five years. However, net income

under the Continued Asian Depression Scenario would average about $2 billion lower

than under the Baseline Scenario during the

next five years.

The farm sector balance sheet continued to

strengthen in 1997, but gains will be limited

from 1998 to 2002. Farm asset values have

risen for 11 years in a row, driven largely by

gains in farm real estate, which averaged 6

percent annually from 1993 through 1997.

The Baseline forecast shows gains in real

estate assets slowing to 2.6 percent in 1998

after 5.8 percent growth in 1997. Real estate

values are forecast to fall in 1999 by 0.6 percent and remain weak through the year 2002

(see Figure 5). The annual average gain in

farmland values over the next five years will

be less than 1 percent, down from 6 percent

during the previous five years. In the Depression Scenario, real estate values will

slowly decline by about 3 percent over the

forecast period.

Total farm debt increased 3.4 percent in 1996

and 3.8 percent in 1997. We expect total debt

to rise just 1.9 percent in 1998 and 1.8 percent in 1999 (Baseline Scenario). Then, farm

debt is forecast to be nearly stagnant through

the year 2002 (see Figure 6). While farmers’

debt-carrying capacity will still be large and

not entirely used, weak financial conditions

will make farmers even more debt-averse.

Average annual gains in farm debt over the

next five years will be around 1 percent (and

will be zero under the Depression Scenario),

down from 3 percent during the previous

five years. Even in the Baseline Scenario we

would expect that, given the weak financial

conditions, the quality of farm debt would

deteriorate—but more so in the Depression

Scenario.

Figure 4

Impact of S.E. Asian Crisis on Net Farm Income $ Billions

42
FCA 1998

Mid-Year Report

Figure 5

Impact of S.E. Asian Crisis on Total Value of Farm Real Estate $ Billions

Figure 6

Impact of S.E. Asian Crisis on Total Farm Debt

Note: Farm Debt of $162 billion for 1997 is reported in USDA’s August 1998 Agricultural Outlook. However, new data

suggest that farm debt in 1997 and 1998 will be about $3-$4 billion higher than reported here.

$ Billions

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FCA 1998

Mid-Year Report

Impact on the Farm Economy by

Farm Credit District

Due to the different commodity concentrations in each of the seven Farm Credit System Districts, the effect of the Continued

Asian Depression Scenario (as compared

with the 1998 Baseline) is different for each

district. Figures 7 and 8 illustrate the average percentage effect on annual net farm

income and farm real estate assets for each

district over the 1998 to 2002 period.

Recall that the 1998 Baseline Scenario already

accounts for the current collapse of the

Southeast Asian economies. The effect of

the collapse itself compared with the old 1997

Baseline, which showed continued strong

economic growth in Asia, cannot be measured directly because the current version of

the model was not available on a districtlevel basis in 1997.

Figure 7

Net Farm Income: Depression Scenario Compared

with 1998 Baseline, by District

Percentages represent annual averages for 1998-2002 period.

Because commodity concentrations vary by district, the impact of the S.E. Asian crisis will be different according to the

major exports of the region. Result is understated in heavy areas of fruit, vegetable, or nut production - Western,

CoBank, and Ag First.

Percent

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FCA 1998

Mid-Year Report

How Will Commodity Prices Be Affected?

Under the 1998 Baseline, most commodity prices (prices for steers, broilers, and milk are

exceptions) will average much lower for the next five years than for the previous five years, as

follows:

Commodity Avg. Price last 5 yrs Avg. Price next 5 yrs Avg. Change

Corn $2.63/bu $2.22/bu Decline $0.41/bu

Wheat 3.79/bu 3.33/bu Decline .46/bu

Soybeans 6.48/bu 5.43/bu Decline 1.05/bu

Cotton 67.98/lb 66.00/lb Decline 1.98/lb

Steers 68.59/cwt 73.9/cwt Rise 5.31/cwt

Hogs 46.65/cwt 42.6/cwt Decline 4.05/cwt

Broilers 57.46/lb 57.8/lb Rise .34/lb

Milk 13.32/cwt 13.66/cwt Rise .34/cwt

Figure 8

Farm Real Estate Assets: Depression Scenario Compared with 1998

Baseline, by District

Percentages represent annual averages for 1998-2002 period.

Commodity concentrations vary by district, the impact of the S.E. Asian crisis will be different according to the major

exports of the region.

Percent

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FCA 1998

Mid-Year Report

Growth in real GDP in Southeast Asia creates growth in demand for U.S. farm exports,

which in turn creates growth in farm prices.

Similarly, declines in GDP create declining

export demand and declining prices. A useful tool for measuring the degree of change

is “elasticity,” which measures the percent

change in a variable that results from a percent change in another variable.

For example, in the model we estimate that

for corn, a 1 percent change in Southeast

Asian GDP creates a 2 percent change in U.S.

farm prices. Thus, if a scenario indicated a

5 percent difference in Southeast Asian GDP,

there would be a 10 percent difference in U.S.

corn prices.

The following summary table lists the effect

on prices of a 1 and a 5 percent decline in

Southeast Asian GDP growth. Recall that

the difference between the 1998 Baseline

Scenario and the Continued Asian Depression Scenario represents a difference of 5

percentage points of growth, so that for the

Continued Asian Depression effect the elasticities are multiplied by a factor of 5. We

then calculate the dollar value of the per-unit

price change for each commodity under the

Continued Asian Depression Scenario. We

have listed the commodities in declining

order of change in the table so that analysts

can easily see which commodities are most

at risk and can use the relationship to calculate their own price changes, given differing

assumptions about changes in gross domestic products in Southeast Asia while other

variables remain equal.

The table shows that when comparing the

Baseline Scenario with the Continued Depression Scenario, cotton and broiler prices

would be affected the most in percentage

terms — that is, their elasticities are higher.

Specifically, cotton prices would average 11.9

cents per pound below the already-reduced

1998 Baseline levels. Wheat prices would be

affected the least and would average 15 cents

per bushel below the already-reduced 1998

Baseline levels.

Vulnerability of Commodity Prices to Changes

in Southeast Asian Growth Rates

(Change in prices in final column can be viewed as the effect of the Depression compared with the

Baseline Scenario)

Unit Price Change Resulting from

1 Percent change in 5 Percent change in Asian Depression—

SE Asia GDP SE Asia GDP change from Baseline

Cotton Price 3.6% 18.0% –11.88 cents per pound

Broiler Price 3.4% 17.0% –9.83 cents per pound

Soybean Price 2.2% 11.0% –$0.60 per bushel

Corn Price 2.0% 10.0% –$0.22 per bushel

Rice Price 2.0% 10.0% –$0.88 per hundredweight

Cattle Price 1.4% 7.0% –$5.17 per hundredweight

Hog Price 1.3% 6.5% –$2.77 per hundredweight

Wheat Price 0.9% 4.5% –$0.15 per bushel

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FCA 1998

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Conclusions

Challenges for the Farm Credit System include managing lending risk to farmers facing greater

price and income risk from the marketplace, without Government price protection. A new

risk—weak commodity markets—could coincide with the elimination of farm program

payments after 2002. Without renewed Government income supports, farmland values will

experience a further decline. Even with the current level of guaranteed payments the updated

Farm Sector Economics forecast shows a slight decline in real estate markets in 1999, with

relatively stagnant asset and debt markets through the year 2002. The national totals forecast

in this article mask the more serious income declines that will be experienced by some. Those

producers heavily dependent on the commodities most affected by the declines in export

demand will experience serious financial stress if market supplies do not adjust to the reality

of lower worldwide demand. Clearly, lenders will have to be very cautious in making assumptions about price projections when reviewing debt repayment capacity.

Opportunities for the Farm Credit System are less apparent with this update, as most of the

risks are now on the downside. However, the Asian economies could recover faster than

projected, which would lead to stronger-than-forecast export markets for major grains, oilseeds, and livestock. This recovery would capitalize into higher real estate values and strengthen

the demand for farm debt—particularly real estate debt. Under this scenario, demand for

non-real estate debt would also expand significantly.

47
FCA 1998

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Farm Credit Administration

Fiscal Year 1999 Regulatory

Performance Plan

Approved by the Board September 23, 1998

The Farm Credit Administration adopts and

issues policy statements and regulations to

help ensure that the Farm Credit System

complies with the law and operates in a safe

and sound manner. As the independent

regulator of the System, the FCA is responsible for protecting the public’s interest. Accordingly, the FCA Board strives to adopt

sound and constructive policies and regulations, take a proactive and preventive approach, and reflect the changing needs of agriculture.

The FCA anticipates another active regulatory period during fiscal year 1999. The attached Fiscal Year 1999 Regulatory Performance Plan (Plan) includes the regulatory

projects proposed for completion in fiscal

year 1999. The Agency also plans to conduct

a complete review of all current regulations

to identify any areas where more flexibility

can allow System institutions to adjust their

structures and lending authorities within the

Farm Credit Act of 1971, as amended. This

review may provide new priorities for the

Plan and may require the Agency to reassess

its current projects for fiscal year 1999. In

addition, the Regulatory Burden notice may

generate comments and create the need for

new regulation projects not currently listed

in the Plan.

As is customary, the Plan details two types

of regulatory actions for fiscal year 1999:

proposed rules and final rules. The purpose

of a proposed rule is to notify the public of

an agency’s intent to revise existing regulations or create new ones. The proposed rule

describes the changes being considered and

tells the public how they may participate in

the rulemaking process. A final rule establishes the basis and purpose for the regulatory revisions or additions that are being

adopted by an agency. The final rule will

advise interested parties how the rule will be

applied, respond to questions and issues

raised during the rulemaking, and serve as a

reference for the future.

Since 1997 we have provided the public with

easy access to FCA regulations through our

interactive Website. The Agency’s goal is

to foster a more interactive relationship and

encourage public participation in the

rulemaking process. The public is invited

to submit comments on individual rulemaking projects via electronic mail to

reg-comm@fca.gov or through the Pending

Regulations section of the FCA’s interactive

Website at www.fca.gov.

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FCA 1998

Mid-Year Report

Regulation Project

Action Date Type of Action Brief Project Description

October – December 1998

Customer Choice Proposed Rule Provide additional flexibility for borrowers to obtain financing

and other financial services from System institutions of their

choice and reduce regulatory burden

Balloting and Stockholder Reconsideration Issues Final Rule Address regulatory burden issues concerning balloting and voter

reconsideration when System institutions engage in corporate

restructuring

January – March 1999

Farm Credit Bank Assistance to Associations Proposed Rule Clarify when Agency consent is needed for approval of financial assistance provided to associations by Farm Credit banks

FAMC Risk-Based Capital Proposed Rule Office of Secondary Market Oversight will make a rule to establish a risk-based capital requirement for Farmer Mac

Release of Information Proposed Rule Conform FCA regulations to Department of Justice guidance

and clarify procedures for processing requests for exempt information

FCS Board Compensation Limits Final Rule Remove Agency prior approval for certain instances in which

bank director compensation can exceed the adjusted maximum

April – June 1999

Investment Management Final Rule Clarify current investment management regulations with respect

to safety and soundness and in response to petitions received to

amend the regulations. Provide guidance consistent with other

financial institution regulators

Regulatory Burden Phase I Action Address comments received from the Regulatory Burden Notice published in August 1998

Leasing Authorities Final Rule Issue comprehensive leasing regulations for all System institutions

July – September 1999

Comprehensive Borrower Rights Proposed Rule Revise the borrower rights regulations to provide clarification

and remove unnecessary burdens

Termination Regulations Proposed Rule Establish regulations under which a bank or large association

within the System can terminate its charter as provided for in

the Farm Credit Act of 1971, as amended

Farm Credit Bank Assistance to Associations Final Rule Clarify when Agency consent is needed for approval of financial assistance provided to associations by Farm Credit banks

Potential Competition Philosophy Projects

Competition Philosophy Projects TBD Projects resulting from the FCA Board Philosophy Statement

on Competition to provide a regulatory environment that will

afford System institutions greater flexibility to adjust their structures and lending authorities within the Farm Credit Act of

1971, as amended

If there are questions on the Fiscal Year 1999 Regulatory Performance Plan, please contact Patricia W. DiMuzio, Director,

Regulation and Policy Division, Office of Policy and Analysis, at (703) 883-4498.

49
FCA 1998

Mid-Year Report

Farm Credit Administration’s Loan

Portfolio Management Symposium

Major changes in the marketplace and in

government policies are bringing more risk

to the agricultural lending environment. Increasingly, the agricultural industry relies on

uncertain foreign markets to maintain its

economic vitality. At the same time, the Federal Agriculture Improvement and Reform

Act of 1996 (FAIR), by reducing the safety

net that many farmers relied on for decades,

has shifted the risk management burden to

producers and farm lenders.

These risks have become reality in 1998, a

year of low market prices for many commodities. Supplies have been abundant, and

export demand has been reduced because of

the financial crisis in Asia. Before this crisis,

Asia was regarded as an important source of

growth in agricultural export demand. Now

that source of demand growth is in serious

doubt. And although farmers are receiving

fixed transition payments as provided by the

FAIR Act, those payments are lower than they

would have been under previous farm legislation.

Farm Credit System (FCS) institutions were

created to provide loans to agriculture in

good times and bad. The inherent risk of

agricultural lending and the statutory limitations on lending authority, which result in

additional risk from credit concentrations in

the FCS, make effective management of loan

portfolios essential. Furthermore, a rapidly

changing and competitive lending environment dictates that FCS institutions manage

their loan portfolios proactively and strategically. Consequently, loan portfolio management has become more important than ever

for Farm Credit institutions.

Indeed, competition is characteristic of the

farm lending market. FCS institutions are

competing for the very best credit customers with commercial banks and insurance

companies, as well as nonbank lenders like

John Deere Credit, Pioneer HiBred, G.E.

Capital Mortgage Services, and a host of

others. If this were not enough, cyber banking over the Internet may also develop into

a real competitive force over time. This is

not a time for successful farm lenders to rest

on their laurels.

The FCA is pleased to sponsor a symposium

that will highlight some of the more critical

and timely issues related to loan portfolio

management. The symposium will provide

a forum for discussing these issues with Farm

Credit colleagues and an impressive group

of expert speakers from around the country.

Discussions of state-of-the-art issues in management information systems, portfolio stress

testing, environmental risk evaluation, and

other key topics make this symposium a

must for proactive Farm Credit leaders.

The symposium is structured for System

personnel, primarily System CEOs, chief

credit officers, and others involved in the

credit function. The Symposium will be held

December 6-8, 1998 at the Fairview Park

Marriott Hotel in Falls Church, Va.

For registration materials for the Loan Portfolio Management Symposium, call the Office of Congressional and Public Affairs at

(703) 883-4056.

50
FCA 1998

Mid-Year Report

Sunday, December 6

5:00- 9:00 p.m.

Check-in and reception

Symposium

Program

Monday, December 7

7:45 a.m. Continental

Breakfast/Registration

Master of Ceremonies

David Kohl, Professor of

 Agricultural Finance,

 Virginia Tech

8:30 a.m. Welcome

Marsha Martin,

 Chairman and CEO, FCA

Thomas McKenzie,

 Director, Office of Policy and

 Analysis, FCA

Future of Agricultural Lending,

Emerging Trends

Michael Boehlje,

 Professor of Agribusiness,

 Purdue University

Loan Portfolio Management in

Commercial Banking

John Barrickman,

 President,

 New Horizons Financial Group

Management Information

Systems for the FCS

Victor Dupuy,

 Senior Manager,

 KPMG Peat Marwick

12:30 p.m. Lunch

Tuesday, December 8

8:00 a.m.

Continental Breakfast

Panel on FCS Portfolio

Management Systems

Paul DeBriyn, President and CEO,

 AgStar ACA

Andy Lowrey, President and CEO,

 AgFirst FCB

Jay Penick, President and CEO,

 Northwest ACA

Collateral Risk – Have You

Factored It Into Your

Portfolio?

Art Clapp, President-Elect,

 American Society of Farm

 Managers and Rural Appraisers

The Role of Marketing in

Portfolio Management

Jim McComb, Senior Consultant,

 Farm Credit Council

 Services, Inc.

12:00 p.m. Lunch

“The Future of U.S. Farm

Policy”

Kika de la Garza,

 former Chairman of the House

 Agriculture Committee

Internal Controls and Loan

Underwriting

Carl Premschak,

 Senior Examiner, FCA

Wrap-up and Summary

Roland Smith,

 Chief Examiner, FCA

2:00 p.m. Adjourn

(Monday, December 7 cont.)

1:45 p.m. Breakout Sessions 1

Stress Testing Your Farm

Loan Portfolio

Joe Davis, President,

 AgriLogic, Inc.

Credit Rating Systems

John Barrickman, President,

 New Horizons Financial Group

Risk Diversification

Robert Bonnet, Chief,

 Guaranteed Loan Making, Farm

 Service Agency and

Tom Clark, Vice President,

 Corporate Relations, Farmer Mac

Lender Liability and

Environmental Risk

Randy Muller, Vice President,

 Environmental Services,

 Bank of America

3:00 p.m. Breakout Sessions 2

Stress Testing Your Farm

Loan Portfolio

Credit Rating Systems

Risk Diversification

Lender Liability and

Environmental Risk

5:00 p.m. Social Hour

6:15 p.m. Dinner

Speaker to be announced
FCA 1998

Mid-Year Report

Corporate Restructuring of Farm Credit

System Institutions

Elna Luopa

Overview

The number of Farm Credit System institutions, including service corporations, declined from 222 on October 1, 1997, to 208

by October 1, 1998. The most significant

decline was in the number of Federal Land

Bank Associations (FLBAs), from 51 to 40 in

one year, as a result of mergers in the Texas

District and formations of direct lender Federal Land Credit Associations (FLCAs), in the

Wichita District. FLBAs affiliated with the

Farm Credit Bank of Texas are also expected

to begin the transition to FLCAs by mid1999 provided the bank’s stockholders approve a proposed plan to transfer direct lending authority. In April 1998, voting stockholders of the Farm Credit Bank of Wichita

approved a plan to transfer direct lending

authority to FLBAs in that district and, as of

October 1, two FLCAs are now operating

within the district. Mergers between Agricultural Credit Associations (ACAs) are also

continuing, and over the past year the number of ACAs has declined by 3 to 57.

Through October 1, 1998, the Farm Credit

Administration (FCA) Board approved 16

corporate applications that have become effective since January 1. These approvals include a plan from a Farm Credit Bank to

transfer direct lending authority to eligible

FLBAs ; approvals to form two FLCAs; eight

association mergers; one change to an

association’s chartered territory; the voluntary liquidation of a service corporation;

amendments that modified the Articles of

Incorporation of a service corporation; one

association headquarters relocation; and one

association name change. Of the eight mergers, three occurred in the AgriBank, FCB District, four in the Farm Credit Bank of Texas

District, and one in the AgFirst Farm Credit

Bank District. This corporate activity is detailed in Table 1. (See the Report on the Financial Condition and Performance of the

Farm Credit System 1997 for corporate activity in 1997 through January 1, 1998).

Wichita Restructuring

On March 10, 1998, the FCA Board approved

the plan submitted by the Farm Credit Bank

of Wichita to transfer direct lending authority to all eligible FLBAs within the District

(Colorado, Kansas, New Mexico, Oklahoma)

provided that the FLBAs obtain approval

from the FCA to operate as FLCAs within a

two-year window beginning July 1, 1998. The

Farm Credit Services of Central Kansas,

FLBA, and Farm Credit Services of Northeast Kansas, FLBA, obtained charters to operate as FLCAs effective July 1, 1998, and

October 1, 1998, respectively.

Texas Restructuring

A similar plan to transfer direct lending authority from the Farm Credit Bank of Texas

(FCBT) to its eligible FLBAs was given preliminary approval by the FCA Board on September 21, 1998. The plan must also be approved by a majority of the voting stockholders of the FCBT before it can be implemented. The district would then have a twoyear window during which individual FLBA

stockholders must approve the plan for their

respective FLBA before the Agency issues an

FLCA charter. Twenty FLBAs originate mortgage loans for the FCBT in Texas, Alabama,

Louisiana and Mississippi.

Liquidation of AgCo Services

Corporation

The Board also approved a plan of voluntary

liquidation of AgCo Services Corporation

(AgCo), a wholly owned subsidiary of

CoBank, ACB. Under the plan, CoBank

agreed to assume all remaining liabilities of

AgCo. The FCA Board cancelled AgCo’s

charter effective at the close of business on

July 22, 1998. Notice of the FCA Board’s

actions with respect to AgCo were published

in the July 27, 1998, Federal Register at 63 FR

40123.

52
FCA 1998

Mid-Year Report

Other FCA Board Actions

Since January 1, 1998, the FCA Board has

granted preliminary approval to a merger of

two ACAs affiliated with AgriBank, FCB, and

the formation of a third FLCA in territory

chartered to the Farm Credit Bank of

Wichita. Agency final approval of these actions is subject to approval by the voting

stockholders of the associations involved.

Pending Applications

As of October 1, 1998, the following applications are pending FCA Board consideration:

(1) a merger of two Production Credit Associations (PCAs) in the Texas District; (2) two

consolidations involving five ACAs in the

AgFirst District; and (3) expansion of territory requests filed by two groups of jointly

managed PCAs and FLCAs; and (4) a name

change request. Action by the FCA Board

on an earlier request—to establish a service

corporation—filed by a PCA affiliated with

the FCB of Texas—continues to be deferred

until further information is provided to the

Agency.

FCA Board Philosophy Statement

on Intra-System Competition

Since its 1916 inception, the Farm Credit

System has evolved with economic and political changes. It underwent many structural

changes during the 1980’s and early 1990’s, a

period of financial crisis and major restructuring within American agriculture. The

System has recovered from its financial crisis

and is, once again, a fully viable lender to

agriculture. Nevertheless, the FCA Board

believes that if the System is to remain relevant as a financial service provider in the

coming century, the System must adapt to

new challenges. As the regulatory environment and markets change and as other financial service providers reach to reinvent

the future, System institutions face the need

to change strategically to retain and better

serve their customers.

On July 14, 1998, the FCA Board adopted a

statement outlining its philosophy that “. . .

unrestricted intra-System competition is

beneficial for the customer and the long-term

relevancy of the Farm Credit System.” In

this regard, the FCA Board supports these

practices:

• flexibility for associations to choose their

source of funding

• System initiatives to allow institutions

to become more efficient and relevant

in the marketplace

• removal of geographic boundaries of

System entities

• movement toward structures that have

broad-based lending authorities encompassing Titles I, II and III of the Act

• broad interpretation of existing statutes

to enable System institutions to become

more competitive and, in the absence

of statutory authority, consideration of

legislative solutions.

Table 2 illustrates the bank and association

structure in each Farm Credit district. Table

3 shows 5-year changes in the numbers of

banks and associations Systemwide. Figure

1 depicts the chartered territories of Farm

Credit System banks.

53
FCA 1998

Mid-Year Report

Table 1

Farm Credit Administration Corporate Activity January 2, 1998 through October 1, 1998

Effective Date Corporate Activity

Affiliated Bank and

Institution

Chartered Name of

Resulting Institution Headquarters Location

10/1/98 Merger FCB of Texas Heritage Land Bank, FLBA Tyler, Smith County, TX

·FLBA of Tyler

·FLBA of McKinney

(continuing FLBA)

10/1/98 FLCA Charter FCB of Wichita Farm Credit Services of Manhattan, Riley County, KS

·Farm Credit Services of Northeast Kansas, FLCA

Northeast Kansas, FLBA

9/15/98 Headquarters Relocation FCB of Texas No change Weatherford, Parker County, TX

·Lone Star FLBA

9/1/98 Merger FCB of Texas

·FLBA of Hillsboro FLBA of Waco Waco, McLennan County, TX

·FLBA of Waco (continuing FLBA)

8/1/98 Merger FCB of Texas Southeast Texas Bryan, Brazos County, TX

·FLBA of Dayton Federal Land Bank Association

·FLBA of Edna

·LaGrange-Bellville FLBA of Bellville

·FLBA of Bryan (continuing FLBA)

7/22/98 Voluntary Liquidation CoBank, ACB Charter cancelled at the close of Denver, CO

·AgCo Services Corporation business on 7/22/98 upon

completion of voluntary liquidation

7/1/98 Merger AgriBank, FCB Badgerland Farm Baraboo, Sauk County, WI

(cob 6/30) ·Harvestland Farm Credit Services, FLCA

Credit Services, FLCA

·Badgerland Farm Credit

Services, FLCA

(continuing FLCA)

7/1/98 Merger AgriBank, FCB Badgerland Farm Baraboo, Sauk County, WI

(cob 6/30) ·Harvestland Farm Credit Services, ACA

Credit Services, ACA

·Badgerland Farm

Credit Services, ACA

(continuing ACA)

54
FCA 1998

Mid-Year Report

55

Table 1

Farm Credit Administration Corporate Activity January 2, 1998 through October 1, 1998

Effective Date Corporate Activity

Affiliated Bank and

Institution

Chartered Name of

Resulting Institution Headquarters Location

Source: FCA, Office of Policy and Analysis, Risk Analysis Division, records.

7/1/98 Merger AgFirst FCB Blue Ridge Staunton, Augusta County, VA

·Warrenton Farm Credit, ACA Farm Credit, ACA

·Staunton Farm Credit,

ACA (continuing ACA)

7/1/98 Merger AgriBank, FCB AgStar Farm Mankato, Blue Earth County, MN

(cob 6/30) ·Farm Credit Services Credit Services, ACA

of St. Cloud, ACA

·Farm Credit Services of Southern

Minnesota, ACA (continuing ACA)

7/1/98 FLCA Charter FCB of Wichita Farm Credit Services of Wichita, Sedgwick County, KS

·Farm Credit Services Central Kansas, FLCA

of Central Kansas, FLBA

7/1/98 Transfer of Direct Lending FCB of Wichita No change in name. Wichita, KS

Authority to Eligible Two-year window in

District FLBAs effect for transfers,

7/1/98-7/1/2000

5/18/98 Amendment to All Farm Credit banks No change in name. St. Paul, MN

Articles of Incorporation ·Farm Credit Leasing Amendments to FCLSC’s

Services Corporation Articles eliminate requirement

for election of directors to board.

Each bank shareholder will

designate a director to

serve on the board.

5/1/98 Charter Amendment AgriBank, FCB Badgerland Farm Fond du Lac,

(expansion of territory ·Badgerland Farm Credit Services, FLCA Fond du Lac County, WI

to add 6 counties) Credit Services, FLCA

5/1/98 Merger FCB of Texas FLBA of Southwest Texas Devine, Medina County, TX

·FLBA of Sonora

·FLBA of Southwest Texas (continuing)

4/1/98 Name Change FCB of Texas PCA of New Mexico Albuquerque,

·Albuquerque PCA Bernalillo County, NM
FCA 1998

Mid-Year Report

Table 2

Farm Credit System Banks and Associations1

(As of October 1, 1998)

Bank Affiliation PCAs FLBAs ACAs FLCAs ACB FCBs BC Total

CoBank, ACB2 0 0 40 100 5

AgFirst FCB 1 0 38 0 0 1 0 40

AgriBank, FCB 18 0 9 18 0 1 0 46

FCB of Wichita 18 20 0 2 0 1 0 41

FCB of Texas 16 20 0 0 0 1 0 37

Western FCB 10 0 5 11 0 1 0 27

AgAmerica, FCB 1 0 1 1 0 1 0 4

St. Paul BC3 0 0 00 001 1

10/1/98 Total 64 40 57 32 1 6 1 201

10/1/97 Total 64 51 60 31 1 6 1 214

Increase/(Decrease) 0 (11) (3) 1 0 0 0 (13)

1. PCA = Production Credit Association; FLBA = Federal Land Bank Association; ACA = Agricultural Credit Association;

FLCA = Federal Land Credit Association; ACB = Agricultural Credit Bank; FCB = Farm Credit Bank; BC = Bank for

Cooperatives.

2. CoBank, ACB has authority to serve cooperatives nationwide and ACAs in CoBank’s Northeast Region.

3. The St. Paul BC serves cooperatives nationwide.

Source: FCA, Office of Policy and Analysis, Risk Analysis Division, records.

Table 3

Numbers of Farm Credit Banks and Associations by Type1, 1994–1998

(As of October 1, 1998)

Year PCAs FLBAs ACAs FLCAs ACB FCBs BCs Total

1998 64 40 57 32 1 6 1 201

1997 64 51 60 31 1 6 1 214

1996 66 69 60 32 1 6 1 235

1995 66 70 60 32 1 7 1 237

1994 69 72 66 31 0 9 3 250

1. PCA = Production Credit Association; FLBA = Federal Land Bank Association; ACA = Agricultural Credit Association;

FLCA = Federal Land Credit Association; ACB = Agricultural Credit Bank; FCB = Farm Credit Bank; BC = Bank for

Cooperatives.

56
FCA 1998

Mid-Year Report

Figure 1

Farm Credit System Banks Chartered Territories

(As of October 1, 1998 )

Source: FCA, Office of Policy and Analysis, Risk Analysis Division, records.

57
FCA 1998

Mid-Year Report

Major Financial Indicators by System, Quarterly Comparison1

At and For the 3 Months ended

(Dollars in Thousands)

Farm Credit System Banks 2,9 Jun 30 ‘98 Mar 31 ‘98 Dec 31 ‘97 Sep 30 ‘97 Jun 30 ‘97

Gross Loan Volume 60,446,778 58,368,049 58,396,451 58,281,477 57,782,928

Formally Restructured Loans3 280,551 259,935 277,963 316,486 296,403

Accrual Loans 90 or More Days Past Due 27,423 27,877 6,311 7,803 11,529

Nonaccrual Loans 250,826 246,135 224,793 263,050 567,088

Nonperforming Loans4 0.92% 0.91% 0.87% 1.01% 1.51%

Cash and Marketable Investments 12,074,904 11,986,065 12,021,111 11,428,955 11,221,146

Total Capital/Total Assets5 8.47% 8.62% 8.53% 8.60% 8.56%

Total URE/Total Assets 4.07% 4.09% 4.03% 4.05% 3.98%

Total Net Income 171,353 169,323 188,721 182,601 165,058

ROA6 0.96% 0.98% 1.07% 1.05% 0.96%

ROE6 11.09% 11.22% 12.27% 12.07% 11.15%

Net Interest Margin 1.49% 1.51% 1.55% 1.63% 1.55%

Operating Expense Rate7 0.47% 0.48% 0.59% 0.53% 0.52%

Associations (excluding FLBAs)9

Gross Loan Volume 38,784,222 36,866,183 36,820,170 36,330,432 35,546,444

Formally Restructured Loans3 68,286 77,017 89,137 76,932 77,216

Accrual Loans 90 or More Days Past Due 44,978 37,917 23,086 20,355 31,134

Nonaccrual Loans 353,709 366,449 367,066 383,250 398,212

Nonperforming Loans4 1.20% 1.31% 1.30% 1.32% 1.43%

Total Capital/Total Assets5 16.11% 16.57% 16.24% 16.22% 16.36%

Total URE/Total Assets 12.47% 12.84% 12.34% 12.49% 12.41%

Total Net Income 170,659 200,655 173,054 156,194 151,526

ROA6 1.72% 2.11% 1.77% 1.61% 1.65%

ROE6 10.25% 12.43% 10.57% 9.70% 9.70%

Net Interest Margin 3.34% 3.47% 3.37% 3.26% 3.45%

Operating Expense Rate7 1.69% 1.77% 1.97% 1.76% 1.83%

Total Farm Credit System8,10

Gross Loan Volume 65,642,000 63,719,000 63,439,000 63,001,000 62,639,000

Formally Restructured Loans3 161,000 176,000 200,000 216,000 220,000

Accrual Loans 90 or More Days Past Due 70,000 65,000 36,000 28,000 41,000

Nonaccrual Loans 604,000 613,000 592,000 646,000 965,000

Nonperforming Loans4 1.27% 1.34% 1.31% 1.41% 1.96%

Total Bonds and Notes 64,415,000 64,415,000 64,479,000 63,964,000 63,362,000

Total Capital/Total Assets5 15.14% 15.10% 14.83% 14.73% 14.54%

Total Surplus/Total Assets 10.96% 10.64% 10.56% 10.36% 10.19%

Total Net Income 329,000 337,000 332,000 328,000 304,000

ROAA6 1.68% 1.72% 1.66% 1.64% 1.61%

ROAE6 11.25% 11.53% 11.42% 11.36% 11.19%

Net Interest Margin 2.92% 2.93% 2.98% 2.99% 2.90%

1. Some of the previously published quarterly data have been restated to include subsequent adjustments.

2. Includes Farm Credit Banks, the Bank for Cooperatives, and the Agricultural Credit Bank.

3. Excludes loans past due 90 days or more.

4. Nonperforming Loans are defined as Nonaccural Loans, Formally Restructured Loans, and Accrual Loans 90 or More Days Past Due.

5. Total capital includes protected borrower capital.

6. Income ratios are annualized.

7. Defined as operating expenses divided by average gross loans, annualized.

8. Cannot be derived through summation of above categories due to intradistrict and intra-System eliminations.

9. Source: FCA Call Reports - Farm Credit Banks and Association Data

10. Source: Farm Credit System Reports to Investors

58
FCA 1998

Mid-Year Report

Major Financial Indicators, By District1, 4

At and For the 3 Months Ended 6-30-98

(Dollars in Thousands)

Farm Credit System Banks Total Gross Nonaccrual Allowance Cash and Capital Earned Total

Assets Loan Loans for Loan Marketable Stock2 Net Net

Volume Losses Investments Worth3 Worth

Wichita 5,176,655 4,197,975 51,668 132,941 959,154 344,741 330,269 674,554

Texas 4,486,037 3,987,477 35,361 51,847 424,341 99,334 258,075 357,408

Western 5,555,701 4,664,498 0 5,000 774,059 204,895 197,021 403,393

Agribank 18,606,787 15,179,289 70,743 217,527 3,335,811 567,242 863,465 1,433,077

AgAmerica 7,873,833 6,774,787 13,708 35,012 1,005,152 550,038 382,688 932,758

AgFirst 10,361,478 8,487,635 0 11,267 1,727,770 308,630 348,880 656,720

CoBank 18,701,284 15,152,780 38,084 238,272 3,509,907 858,251 557,925 1,422,178

St. Paul BC 2,407,853 2,002,337 41,262 54,071 338,710 281,883 36,951 318,754

Total 73,169,628 60,446,778 250,826 745,937 12,074,904 3,215,014 2,975,274 6,198,842

Associations (excluding FLBAs)

Wichita 964,649 883,294 4,978 27,846 15,890 46,692 160,891 207,818

Texas 906,465 842,248 9,375 25,385 4,035 64,130 158,247 222,377

Western 5,578,449 5,249,715 39,251 115,929 51,445 132,970 727,820 860,790

Agribank 15,239,505 14,337,635 115,497 270,037 55 300,964 1,939,827 2,246,078

AgAmerica 7,354,421 6,805,004 79,397 295,506 16,255 67,769 999,630 1,111,241

AgFirst 9,214,760 8,821,818 82,710 251,277 4,109 215,913 1,468,359 1,721,426

CoBank 1,962,024 1,844,508 22,501 50,140 7,892 50,264 306,487 356,751

Total 41,220,273 38,784,222 353,709 1,036,120 99,681 878,702 5,761,261 6,726,481

FCS Totals 78,164,000 63,719,000 613,000 1,848,000 12,807,000 1,872,000 8,564,000 11,907,000

1. Aggregations of district data may not equal totals due to eliminations.

2. Includes protected borrower capital.

3. Excludes accumulated other comprehensive income

4. Source: FCA Call Reports - Farm Credit Banks and Association Data

59
FCA 1998

Mid-Year Report

Glossary

Terms have the following meanings as used

herein:

A

ACA—Agricultural Credit Association, the

successor association resulting from a Federal Land Bank Association/Production

Credit Association merger

ACB—Agricultural Credit Bank, the successor resulting from a Bank for Cooperatives/

Farm Credit Bank merger

Agency—Farm Credit Administration

Associations—Federal Land Bank Associations, Federal Land Credit Associations, Production Credit Associations, and Agricultural

Credit Associations

B

Banks—The Farm Credit Banks

banks—The Farm Credit Banks, the Agricultural Credit Bank, and (sometimes) the

Bank for Cooperatives

BC—Bank for Cooperatives

Consolidated Bank Debt Securities—debt securities issued by a combined Bank group

pursuant to Section 4.2(c) of the Farm Credit

Act

D

DL—direct lender

F

Farm Credit Act—Farm Credit Act of 1971,

as amended

FCA or Agency—Farm Credit Administration

FCB—Farm Credit Bank

FCS or System—Farm Credit System

FLBA—Federal Land Bank Association

FLCA—Federal Land Credit Association, a

Federal Land Bank Association that has been

granted direct lending authority

Funding Corporation—Federal Farm Credit

Banks Funding Corporation

G

GSE—government-sponsored enterprise

Insurance Corporation—Farm Credit System Insurance Corporation

Insurance Fund—Farm Credit Insurance

Fund, maintained by the Insurance Corporation pursuant to the Farm Credit Act

O

OPA—Office of Policy and Analysis

P

PCA—Production Credit Association

R

RCD—Risk Control Division

ROAA—return on average assets

ROAE—return on average equity

S

System—the Farm Credit System

Systemwide Debt Securities—Federal Farm

Credit Banks Consolidated Systemwide

Bonds, Federal Farm Credit Banks Consolidated Systemwide Medium-Term Notes, Federal Farm Credit Banks Consolidated

Systemwide Discount Notes, and any other

debt securities that may be issued by the

Banks pursuant to Section 4.2 (d) of the

Farm Credit Act

U

URE—unallocated retained earnings

USDA—U.S. Department of Agriculture

60
FCA 1998

Mid-Year Report